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Spring 05 Cover FINAL v.5.ps - 4/11/2005 10:52 AM

SPRING

2005

THE

FEDERAL

RESERVE

BANK

OF

AFFORDABLE
HOUSING . . .
Are home prices
soaring beyond
your reach?

Underground Economy • Sticky Prices
Biometrics • Interview with Thomas Schelling

RICHMOND

Spring 05 Cover FINAL v.5.ps - 4/11/2005 10:52 AM

COVER STORY
10

Homeward Bound: Housing markets work just fine for most
people. But certain markets in the Fifth District aren’t producing homes and apartments that working families can afford
From Washington, D.C., to Charlotte, N.C., much of the Fifth District’s
supply of new housing consists of spacious, pricey homes. This has put
the squeeze on people earning at or near the median. Analysts point to
land-use restrictions as a key culprit behind runaway housing costs.

FEATURES
16

Searching for the Hidden Economy: Economists believe as much
as 10 percent of the U.S. economy is “underground.” Is that such
a bad thing?
The hidden economy takes many forms – from scrip currency in rural
Appalachia to walk shoveling in Richmond, Va. — and it’s not always as
sinister as it sounds. But the size of the underground economy is as much
in debate as its meaning.
20

Sticky Situation: Some prices are slow to change. Are they sticky
enough to affect monetary policy?
Nobody doubts their existence, but many question their importance.
Some leading economists, including a widely cited Richmond Fed
researcher, hold sharply divergent views about the importance of sticky
prices and their impact on the economy.
24

The Dollar Dilemma: The falling dollar has made American
goods more attractive to consumers abroad, but not everyone
is happy about the currency’s slide
The dollar’s decline has been good news for many Fifth District firms.
Whether further depreciation portends wider trouble for the U.S.
economy remains to be seen.
26

The Identity Business: Biometrics cluster sharpens West
Virginia’s economic image
The Federal Bureau of Investigation’s Criminal Justice Information
Services Division in Clarksburg, W.Va., has spawned a cluster of businesses
related to biometrics, the science of measuring physical characteristics to
determine identity.
30

The Future of Community Banking: A decade ago, small banks
were being gobbled up by big banks, but those days seem to be
over. What are they doing now?
The economic role of community banks has evolved over the past 20
years, and nowhere is that more apparent than in the Fifth District.

DEPARTMENTS

P H OTO G R A P H Y: STO C K BY T E /G E T T Y I M AG E S

1 Noteworthy/Encouraging Homeownership — at What Cost?
2 Federal Reserve/New Times for Fed Branches
5 Policy Update/Tax Increment Financing
6 Jargon Alert/Zero-Sum Game
7 Research Spotlight/Causes of Terrorism
8 Short Takes
32 Economic History/Making Furniture in North Carolina’s Piedmont
36 Interview/Thomas Schelling
42 Book Review/Fighting Poverty in the U.S. and Europe:
A World of Difference
44 NEW Regional/District Economic Developments
52 Opinion/Evil Empire?

VOLUME 9
NUMBER 2
SPRING 2005

Our mission is to provide
authoritative information
and analysis about the
Fifth Federal Reserve District
economy and the Federal
Reserve System. The Fifth
District consists of the
District of Columbia,
Maryland, North Carolina,
South Carolina, Virginia,
and most of West Virginia.
The material appearing in
Region Focus is collected and
developed by the Research
Department of the Federal
Reserve Bank of Richmond.
DIRECTOR OF RESEARCH

John A. Weinberg
EDITOR

Aaron Steelman
SENIOR EDITOR

Doug Campbell
MANAGING EDITOR

Kathy Constant
BUSINESS WRITERS

Charles Gerena
Betty Joyce Nash
E D I TO R I A L A S S O C I AT E

Julia R. Taylor
CONTRIBUTORS

Joan Coogan
Andrew Foerster
Eric Nielsen
Christian Pascasio
Jennifer Wang
ECONOMICS ADVISERS

Andrea Holland
Robert Lacy
Ray Owens
C I RC U L AT I O N

Walter Love
Shannell McCall
DESIGN

Ailsa Long
Published quarterly by
the Federal Reserve Bank
of Richmond
P.O. Box 27622
Richmond, VA 23261
www.richmondfed.org

Subscriptions and additional
copies: Available free of charge
by calling the Public Affairs
Division at (804) 697-8109.
Reprints: Text may be reprinted
with the disclaimer in italics
below. Permission from the
editor is required before
reprinting photos, charts, and
tables. Credit Region Focus and
send the editor a copy of the
publication in which the
reprinted material appears.
The views expressed in Region Focus
are those of the contributors and not
necessarily those of the Federal Reserve
Bank of Richmond or the Federal
Reserve System.
ISSN 1093-1767

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:11 PM

NOTEWORTHY
Encouraging Homeownership — at What Cost?
s the cover story of this
issue of Region Focus makes
clear, affordable housing
is a significant problem for many
Americans. There are several reasons for the mismatch between
consumer demand on the one
hand and market supply on the
other. In particular, land-use
regulations appear to be an
important factor driving up prices
in some of the Fifth District’s
highest growth regions. Policymakers should consider the
costs such regulations impose on society before enacting or
expanding these rules.
Reconsideration may also be worthwhile for the dominant policy response to shortages of affordable housing. In
general, governments have preferred to subsidize the consumption of housing in various ways rather than to provide
cash transfers to support the incomes of those most hurt by
high housing costs. But it’s not clear that this approach is a
particularly efficient means of helping such consumers. It
may have induced them to obtain more housing and less of
other goods than they would have in the absence of such
subsidies. Providing people with cash transfers, in contrast,
would be a more direct solution to the problem and would
let them choose how best to allocate their resources. It is a
well-established economic principle that the provision of
cash or cashlike assistance is the most cost-effective way to
improve the well-being of low-income households. There is
really nothing special or different about housing that suggests that deviation from this principle is warranted.
So if cash transfers would be a more desirable policy response, why do we subsidize housing instead? One reason
— associated specifically with homeownership — may be the
supposed “positive externalities” associated with ownership.
Many believe that benefits accrue not just to the homeowners but to the larger community as well. For instance,
several studies have suggested that homeowners tend to be
more active in their communities, by participating in charitable, social, and political groups at relatively high rates.
Others have claimed that homeowners tend to lead healthier, happier lives, thus reducing total public expenditures on
medical care. And, finally, some have argued that homeowners generally take better care of housing than do renters,
contributing to more pleasant, stable neighborhoods.
The last argument seems consistent with economic
theory. We would generally expect owners to maintain things
better than people who are just temporary stewards of the

A

property. And insofar as landlords often have difficulty
assessing the character of prospective renters or monitoring their behavior once they have moved in, we might
expect that rental properties will receive less care from their
occupants.
The other examples of positive externalities discussed
above may have causation problems, however. Community
activism and personal health could be associated with homeownership but not a result of it. We know that, on average,
homeowners tend to be wealthier than renters. But we also
know that wealthier people tend to be more active in their
communities as well as healthier than those near the
bottom of the income distribution. Which factor — homeownership or wealth, or even some other, unobserved
factor that is correlated with both of these — is driving
higher rates of community activism and health? It’s not
obvious.
In addition, there may be social costs associated with
homeownership, especially for low-income people. Homeownership often makes it more difficult for people to move
from one place to another — mobility that might be especially valuable to those in search of better jobs. Renting may
make it easier for them to relocate for a position that more
closely suits their skills. Also, low-income households have
more difficulty weathering sudden drops in income and large
unexpected expenditures, which could lead to foreclosure.
As William Rohe, Shannon Van Zandt, and George McCarthy
of the University of North Carolina’s Center for Urban and
Regional Studies have noted, “While breaking a lease on a
rental unit is problematic, the stress and trauma caused by
defaulting on a mortgage is much more serious.”
Overall, then, I think we should be cautious about pursuing policies that aim to increase homeownership. For some
people, owning a home is clearly a good decision, which will
benefit them and their neighbors. But for other people,
renting may make more sense — again, for both the renters
and society generally. I don’t see a strong reason to tilt the
playing field in favor of one choice or the other, especially
when the public benefits and costs of encouraging homeownership are so uncertain.

JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND

Spring 2005 • Region Focus

1

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FEDERALRESERVE
New Times, New Functions
BY J E N N I F E R WA N G

As the economy
changes, so does
the role of Federal
Reserve Bank
branch offices

he Federal Reserve System and
its 12 banks owe their existence
to the Federal Reserve Act of
1913. This landmark legislation
famously reflected the model of so
many American institutions: to be at
once centralized and decentralized.
The Board of Governors sits in
Washington, D.C., and formulates U.S.
monetary policy in coordination with
the Reserve bank presidents. It’s a
system of geographic checks and
balances, with the centralized board
relying on the firsthand regional economic knowledge of the decentralized
bank chiefs, whose main offices are
located in cities around the country.
And of course, this knowledge
exchange works both ways.
But even divided among 12 Reserve
banks, the entire United States is a lot
of turf to cover. For this reason, many
Reserve banks also keep branch
offices. Since the very beginning, the

T

1-12 Federal Reserve Districts
★ Board of Governors/Washington, D.C.
★
Federal Reserve Bank Cities
Federal Reserve Branch Cities
NOTE: Districts 1 and 3 don’t have branch offices.
SOURCE: Board of Governors of the Federal Reserve System

2

Region Focus • Spring 2005

role of these branches has been in
some debate. At first, branches were
envisioned as miniature Reserve
banks, doing everything the main
office could do but on a smaller scale.
Then they became more like repositories for specific functions like check
clearing. And the discussion has grown
more complicated in the past decade
with advancing technology and the
evolving functions of the Federal
Reserve System itself.
The Federal Reserve Act stated
that there would be between eight and
12 Reserve banks, and cities eagerly
vied for the opportunity to be home to
one. But beyond the number of
Reserve banks to be created, there was
also considerable uncertainty over the
nature and scope of the banks’ responsibilities — an uncertainty compounded by the speed with which the banks
were to be established. In addition,
confusion arose during the discussion
of Reserve bank branch offices. It was
even less clear what powers these
branches would have, and what role
they would play within the System.
Twenty-five branch offices would
eventually emerge, the number varying
from district to district, determined by
the needs of the individual Reserve
banks. The Fifth District (Richmond),
for example, maintains two branches —
one in Charlotte, another in Baltimore
— while the Sixth District (Atlanta) has
fives branches, and the First and Third
Districts (Boston and Philadelphia,
respectively) have none. Many districts
also are home to regional checkprocessing centers, though the number
of these centers has dropped recently.
Early on, regional branch offices
largely supported the main Reserve
banks in an operating capacity, providing functions such as check clearing
and cash processing. Over the years,
the branches have adapted to the
evolving needs of their respective

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:11 PM

Vanishing Checks
The rapid drop in paper checks is the
most urgent factor driving change at the
branches, and has resulted in a sizeable
scaling down of infrastructure. Though
checks remain the most popular form of
noncash retail payment, from 1995 to
2002 the number of checks written fell
by roughly 10 billion. In 2003, the number of electronic payments through
credit cards, debit cards, and similar
instruments exceeded the number of
check payments for the first time — by
more than 8 billion — and the gap is
expected to widen over time.
Major changes at the Fed also
began in 2003. A significant Fed initiative sought to reduce check service
operating costs as the market environment signaled a shift in consumer and
business preferences from checks to
electronic payments. The initiative
proposed an annual review of the
check processing operations network
for consolidation opportunities; nearby offices would be collapsed into one
another to take advantage of
economies of scale. When the scheduled office moves are completed next
year, checks will be processed in 23
locations (down from 45), and the
overall check staff will be reduced by
about 400 positions.
In the Fifth District, the Richmond
bank closed its check processing centers in Charleston, W.Va., and
Columbia, S.C. The checks that had
been processed in Charleston were
sent to the Cleveland Fed’s Cincinnati
branch, and those processed in
Columbia went to Charlotte. In addition, all of the checks processed at the
main office in Richmond were moved
to the Baltimore branch.
David Beck, vice president and
interim branch manager at the
Baltimore office, explains the effect of
the consolidations. “All of Virginia territory is now in Baltimore, causing

Baltimore’s check volume to rise initially by 70 to 80 percent,” he says. “But
because of an overall decline in volume,
that percentage has not held up.”

Electronic Payments Have
Increased as Check Volume
Has Declined
90

The Eighth District’s Response
Many of the districts faced substantial
challenges when the check restructuring process began. But in the Eighth
District, St. Louis Fed President
William Poole described the impact as
“seismic.” With its Louisville branch
only 100 miles from Cincinnati, and
Little Rock just 120 miles from
Memphis, it was difficult to justify
maintaining operations at all the
branches. It was ultimately decided
that operations at the Louisville and
Little Rock branches would be completely shut down and the buildings
sold. The staff — reduced to fewer
than 10 employees at each branch —
would work in leased space.
These announcements raised questions concerning the necessity of keeping the Little Rock and Louisville
branches at all. But the Eighth District
decided that they still served a vital purpose. In the St. Louis Fed’s 2003 Annual
Report, President Poole stated that his
district “cannot afford to lose or lessen
the importance of the network of economic information-gathering resources
we’ve established, the critical input we
get from our branch boards of directors
on the regional economy, and the oneon-one relationships we’ve nurtured
among the region’s bankers, teachers,
community development agencies, and
university professors.”
Indeed, nearly all Reserve bank
presidents cite the vital role of branch
offices in providing up-to-date information on the state of the economy,
which they use in preparing for Federal
Open Market Committee deliberations. That information, though often
anecdotal, can provide valuable
insights about what is happening
around the districts before formal statistical reports are released.
While Poole and his colleagues rely
on the branches to provide them with
timely reports on economic conditions,
the branches are trying to increase their
public visibility within the communi-

Electronic Payments
Paper Checks

80
NUMBER OF PAYMENTS (IN BILLIONS)

Reserve banks. Some, for instance,
have seen their role in the payments
system decline sharply, while others
have taken on new responsibilities in
the areas of community affairs and
bank supervision and regulation.

70
60

15.1

30.6

44.5

50
40
30

5.5

20

29.6

49.5

41.9

36.7

1979

1995

2000

2003

10
0
SOURCE: Federal Reserve System

ties they service. According to Randall
Sumner, vice president of public and
community affairs at the St. Louis Fed,
“One way of doing that is devoting
more effort to economic education and
regional economic research activities.”
Thus far, Sumner believes the transition at the branches has been a smooth
one. “This year, we’re going to be taking
advantage of the skills of the new
people we’ve hired,” he says. “The proof
will be what it looks like at the end of
the year. But we’re all very excited and
have every confidence in its success.”

The Fifth District’s
Unusual Situation
The Fifth District is relatively unique
among Reserve bank districts. Its
branch offices are located in much larger metropolitan areas than its main
office. This is one reason why, for now at
least, check-processing will remain a
principal activity in Baltimore and cash
operations will continue to be significant in Charlotte. Also, because
Charlotte is home to some of the
nation’s largest financial institutions,
banking supervision and regulation has
become a crucial function there, as has
community outreach.
Beck points out that Baltimore is
“one of the largest branches in the system. And the Baltimore-Washington
metropolitan area we serve is certainly
a lot bigger than, say, Little Rock or

Spring 2005 • Region Focus

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Louisville. So I think checks and
cash operations will remain here for
a number of years.”
Jeff Kane, senior vice president
and head of the Charlotte office,
emphasizes the unique status of the
Charlotte branch. “I bristle when
people talk about branches as generic operations. When you look at the
banking presence in the Carolinas, it
far outweighs anything else outside
of New York.”
In the past, Kane says, “We have
thought of our branch as an operational facility. Visitors came in here
and we gave them a tour of the
checks and cash departments, for
instance.” But that’s changing, as the
Fed seeks to increase its presence
within the local community.
Many of Charlotte’s big commercial banks have important long-standing ties to the region. “There’s not a
board of directors of a nonprofit
group, charitable organization, or local
university that is not touched by those
banks in a significant way,” Kane
notes. He would like to see the
Richmond Fed’s Charlotte office take
part in similar activities. Although
careful to point out that he doesn’t
have the staff to equal the “visibility of
a commercial banking organization
that employs 250,000 people,” Kane
says he is working to increase “the
presence of the branch in those circles
in which we operate.”
There are obvious reasons for the
expanded role of the Charlotte office
and of branch offices throughout the
Federal Reserve System, Kane says.
“What do we all have in common? The
answer is we are all tied to the local
economy and to the prosperity of the
region, and because of that it makes
sense for the branches to increase our
community outreach activities.”

“Reserve bank
presidents cite the vital
role of branch offices
in providing up-to-date
information on the
state of the economy,
which they use in
preparing for FOMC
deliberations.”
A New Leg
One of the most popular metaphors
for the Fed is the image of a stool, with
three legs representing each of the
three main areas traditionally under
the Fed’s jurisdiction. There is a monetary policy and research leg, a banking supervision and regulation leg, and
a financial services and payments
mechanism leg. Recent and forthcoming efforts to increase the Fed’s community outreach activities, though,
may lead to the addition of a fourth leg
— a type of public education/community outreach leg.
Jeff Lacker, president of the
Richmond Fed, says, “If you look at
where our head office is and where our
branches are across the district, it’s
clear that the branches have an important role to play in connecting us to our
district.” Besides plans to improve economic education and financial literacy
programs in the region, efforts to
expand regional economic research also
will be strengthened. “We’ve always
monitored regional economic conditions out of our head office. But you can
only do so much of it from Richmond.

We have a very diverse region, and it’s
important to be aware of those differences. So we’re looking to hire regional economists to put into those offices
who would be able to focus on the
region around the branch.” Additionally, Lacker envisions hosting events in
cities throughout the district. “That’s
an area where I think the branches can
play a role. They have a presence in
their regions, and we can use them to
reach out to the communities.”
Banking is an area in which the Fed
takes a keen interest, of course, and
the freeing up of resources once
devoted to payment systems operations may help the Fed build and sustain stronger relationships with private banks through its regional offices.
“We’ve generally tried to maintain a
relationship with banks that goes
beyond our supervisory function,
which encourages them to feel as if
they can communicate with us about
any banking issue that’s of concern to
them,” Lacker says. “Even if we can’t
pass a law for them, we want them to
feel as if we understand what’s going on
in their industry. We’re going to be
looking for ways to foster that dialogue
with the banking industry.”
The functions of Reserve bank
branch offices have recently undergone significant changes. But their
purpose has, in one sense, remained
the same: to assist the main office in
carrying out its aims and objectives.
Lacker concludes, “If you look at
the System from the point of view of
the way it was designed in 1913 — as 12
banks as opposed to one big bank —
it’s clear Congress meant us to be very
well connected to our districts. We
need to really know what’s going on
and to be responsive, and the branches
have an important role to play in helping us achieve that goal.”
RF

READINGS
Greene, Stephen. “Branching Out: The St. Louis Fed’s Three
Branches Extend Beyond Bricks and Mortar.” In the Federal
Reserve Bank of St. Louis 2003 Annual Report, pp. 6-20.
Hammes, David. “Locating Federal Reserve Districts and
Headquarter Cities.” The Region, September 2001, vol. 15,
no. 3, pp. 24-27 and 55-65.

4

Region Focus • Spring 2005

Harless, Doris E. “The Federal Reserve Bank of Richmond: A
Brief History.” Cross Sections, Fall 1989, vol. 6, no. 3, pp. 8-9.
Visit www.richmondfed.org for links to relevant sites and
supplemental information.

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:11 PM

POLICY UPDATE
Betting on the Future to Finance the Present
BY C H A R L E S G E R E N A

W

bonds depends on development occurring where it supposedhile other sports teams demand that taxpayers fund
ly would not have happened, this uncertainty could scare off
new stadiums, the Richmond Braves have offered
investors. South Carolina had this problem until municipalito build their own ballpark as part of a $330 million
ties were allowed to offer water and sewer revenues as
development. The catch is the minor-league baseball club wants
a backup source of debt payments.
to use tax increment financing (TIF) to cover the stadium’s
A locality also can promise to appropriate general funds if
$80 million cost. Cities and counties throughout the Fifth
incremental revenue from a TIF-designated area falls short.
District use this mechanism, but TIF isn’t the free lunch that
“It’s not a binding obligation,” but a good faith
its supporters portray it to be.
provision, says John Petersen of George Mason University’s
California pioneered TIF in 1952 and a few states followed.
School of Public Policy. Still, a locality is unlikely to let a TIF
The mechanism became more widely used in the 1970s and
bond default because doing so could hurt its credit rating.
’80s. West Virginia and North Carolina were among the last
This arrangement exists in Richmond, where streetscape
states to embrace TIF, with voters approving this approach in
work on Broad Street and the construction of downtown
2002 and 2004, respectively.
parking garages are being funded with
Here’s how it works. Municipalities
TIF. If the taxing district yields a
issue debt to pay for public improveTIF Projects In Action
lower amount of parking fees and
ments. The debt is repaid using just the
District of Columbia: Mandarin Oriental Hotel,
other revenue than what is necessary
revenue generated by increases in propGallery Place (mixed-use development)
to cover the bond payments, the city
erty values, retail sales, or other taxable
Maryland: Toys-R-Us distribution center in
has promised to pay up to $3 million of
activities within a designated area that
Frederick County; Park Place in Annapolis
the shortfall.
benefits from the improvements.
(mixed-use)
To minimize these risks and make
Typically, a separate development
South Carolina: Sewer and road improvements
TIF more attractive to investors, local
authority issues the debt in the form of
in Hilton Head; Manchester Village in Rock Hill
officials may ask for a letter of credit
tax-exempt bonds.
(mixed-use)
from the developer or keep the proTIF’s main selling point is that
Virginia: MacArthur Center in Norfolk (regional
ceeds of a TIF in escrow until a project
localities can encourage private investmall); Town Center of Virginia Beach (mixed-use)
meets certain milestones. More comment in economically distressed or
West Virginia: Extension of sewer lines in growmonly, they wait until economic
blighted areas without dipping into
ing residential areas in Raleigh County; Square at
growth is already occurring in an area
their budgets directly. They also avoid
Falling Run in Morgantown (mixed-use)
before approving the use of TIF, or
issuing general obligation bonds,
which requires public approval.
they recapture revenues from a
(Charlotte voters, for example, soundly rejected a bond issue
broadly drawn taxing district that includes nearby businesses.
to pay for a new basketball arena and minor-league ballpark in
These latter tactics contradict the idea that TIF should
2001.) Such bonds also count against a locality’s debt limits.
support development that wouldn’t have occurred otherwise.
Studies have shown that TIF can have positive effects on
In West Virginia, TIF has been used mostly in areas where the
property values of designated areas, but that growth may
population is growing, not in counties that have been losing
come at the expense of other places. “When you build a TIF
residents and lacking economic development.
[project], it drains development out of the rest of the city,”
Even when new development occurs as planned, TIF often
says economist David Merriman of Loyola University
still represents an opportunity cost to taxpayers. The increChicago, who co-authored a 1999 paper on how TIF has
mental increases in tax revenue that would have gone to a variaffected growth patterns in the greater Chicago area.
ety of general purposes instead go toward repaying debt for 20
Of course, redistributing wealth to blighted communities
years or more. Further, that revenue is unavailable to fund
may be the goal of TIF users. Several states, for instance, have
services needed by new businesses or residents.
a “but-for” test that requires TIF to be used for public
Despite these costs and risks, communities may still be
improvements in a location only if private development
willing to leverage tomorrow’s tax revenues in order to influwouldn’t have take place there. But proving such a thing is
ence the pace and nature of development today. “The comoften difficult to do, says Merriman and others.
munity can go to the developer and say, ‘We can provide a lot
This highlights an important risk. Bond investors must be
of your basic financing at a cheaper rate … but here’s the
assured that they will receive their payments, or few TIFkind of project we want,’” says Petersen. For developers,
backed projects will go forward. Since repayment of TIF
that’s a difficult offer to refuse.
RF

Spring 2005 • Region Focus

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JARGONALERT
Zero-Sum Game

E

conomic life is often compared to a game. In many
ways, this is an accurate characterization. Participants
in the economy try to maximize their outcomes within a rule-based structure, much as players of a game do. As
such, some economic actors are very successful, while others
appear to get left in the dust.
At one time or another, most people suffer some sort of
economic setback. People may invest their money poorly,
lose their jobs, or find that their skills and knowledge have
become obsolete. The high visibility of these negative outcomes has led some pundits, and a few economists, to argue
that the economy functions as a zero-sum game.
Just what is a zero-sum game? Mathematically, a zero-sum
game is one in which the sum of all the gains and losses made
by all the players must be zero. This is the familiar idea that
one man’s loss is another man’s gain. For
example, poker is a classic zero-sum
game. At the end of the night, the
total amount of money involved in
the game is the same as at the start
of the game. Thus, any money made
by one player must come at the
expense of the others.
Is it fair to argue that a market
economy works the same way as a zerosum game? Must every economic action
have losses as big as the gains? No.
The first flaw in the zero-sum
argument is the implicit assumption
that a fixed basket of goods has the
same value to all people. But the same
good may have different utilities for different people. For
example, I might not value a designer dress at all since I have
no use for it, but my sister might highly value the dress.
Thus, with a fixed array of goods, different combinations of
those goods will lead to different overall levels of utility.
More important, the total amount of wealth in the world
is not fixed. Consider the example of Henry Ford and the
automobile. In 1908, Ford introduced the Model T, the first
mass-produced and widely affordable car in history. Through
his innovative use of assembly lines, Ford was able to produce reliable cars at relatively low cost. By 1927 he had sold
15 million cars, his company employed well over 100,000
workers at wages double industry standards, and almost
7,000 Ford dealerships had been opened across the country.
Needless to say, Ford himself became extremely
wealthy in the process. However, Ford also greatly
increased the wealth of countless others through his innovations. He provided high-paying jobs to thousands of
6

Region Focus • Spring 2005

workers while producing a much-valued new good to the
burgeoning middle class.
The Ford example demonstrates that the level of wealth
in a society is not fixed. Though the supply of some raw
materials is limited, technological improvements are
constantly increasing the productivity, distribution, and
quality of the goods produced from these materials. These
changes make virtually everyone better off. Thus, most
economic activity cannot be called zero-sum games.
Still, it is possible for some people to suffer losses. For
example, many manufacturing jobs have moved from
wealthy countries such as the United States to developing
countries, leaving many U.S. workers without jobs, at least
temporarily. The economic hardships that result from
globalization are real, and there is justifiable interest in
implementing public policies that will
better prepare American workers to
succeed in a changed environment.
But we also must remember that
globalization increases the efficiency
of the world economy by allocating
resources to their maximum effect. In
fact, trade is a perfect example of what
is known as a positive-sum game.
Some jobs are lost in the process, but
overall those losses are more than offset in the long run by cheaper goods
and the movement of capital into
more competitive projects.
It’s useful to consider the Ford example again in this context. The introduction
of the Model T surely harmed other auto manufacturers that
were unable to compete with Ford’s new product. But many
millions of people were benefited in the process, making it a
positive-sum game.
Are there also examples of negative-sum games? Yes.
Certain government regulations, for instance, can produce
such outcomes. Consider Manhattan’s housing market. The
city of New York imposes rent controls on some apartments,
which cap the rents that landlords are allowed to charge tenants. This regulation provides a disincentive to maintain the
existing housing stock or to add to it. The result is a negative-sum game. Those who can secure a rent-controlled
apartment are made better off. But the majority of New
Yorkers wind up paying higher rents because there is not
enough supply to meet demand.
It’s important to remember that this example is unique.
Zero-sum games can occur, but they are unusual and often the
result of public intervention into private markets.
RF

ILLUSTRATION: TIMOTHY COOK

BY E R I C N I E L S E N

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:11 PM

RESEARCHSPOTLIGHT
An Economist Considers the Causes of Terrorism
BY A N D R E W F O E R ST E R

Lower-income countries have higher terrorist risks not
ince Sept. 11, 2001, terrorism has been firmly planted
because they are poor but because they generally have addiin the public’s mind. While much of the policy debate
tional characteristics that fuel terrorist activity, Abadie
has focused on measures that might help prevent
says. In other words, there is no causal link between poverfuture attacks, some economists have turned to analyzing
ty and greater terrorist risk.
the factors that breed such risks in the first place.
The level of political freedom in a country, for instance,
Much of that work has concluded that poverty is a core
is an important factor in determining how much risk a councause of terrorism. But Alberto Abadie, an economist at
try may face. How does this process work? “Over most of the
Harvard University, argues that there are other, more imporrange of the political rights index, lower levels of political
tant factors, including a country’s level of political freedom,
rights are associated with higher levels of terrorism,” Abadie
its degree of linguistic diversity, and its natural terrain or
writes. But this is untrue of highly authoritarian countries.
geography.
The policies those countries adopt to stifle political dissent
Previous studies on terrorism also make a crucial mistake by
may help keep terrorism at bay, Abadie argues.
exclusively considering international acts of terrorism, argues
Thus, both free societies as well as authoritarian ones tend
Abadie, a native of Spain’s Basque region, which is home to a
to be at less risk than those in the middle — countries with
strong separatist movement that wants political independence
moderate levels of political freedom. Those risks may be
from Madrid. These studies use statistics provided by the U.S.
especially acute for countries like Russia and Iraq, which are
State Department, which include only those terrorist acts that
making the transition from
involve citizens and property of
authoritarian political systems
multiple countries.
to more democratic ones.
A significant number of
“Poverty, Political Freedom, and the
Internal strife caused by
terrorist attacks, however, are
ethnic
or religious differences
carried out domestically —
Roots of Terrorism” by Alberto Abadie.
also may elevate the risk of
involving citizens and property
terrorism, some analysts have
of a single country. Abadie notes
National Bureau of Economic Research
argued. But the real key is not
that in 2003 alone, there were
ethnicity per se, but the num1,536 accounts of domestic
Working Paper 10859. October 2004.
ber of languages spoken in a
terrorism compared to 240
country, Abadie says. The highinternational accounts.
er the probability that two people from a given country speak
Abadie uses data from the World Market Research
different languages, the higher the country’s terrorist risk.
Center’s Global Terrorism Index to estimate the risk of
Geographic factors also are important. Three key variables
terrorism. These forecasting data consider the risk of attack
increase a country’s risk: size, elevation, and the fraction of the
against 186 countries around the world and their respective
country that is tropical. Certain features, such as mountains or
interests abroad, such as embassies.
rain forest, provide potential terrorists with relatively safe
So what factors increase the risk of terrorist attacks?
training grounds. Geographic characteristics also contribute to
As noted above, many economists have argued that wealth
the production of illegal drugs, which are sold to finance
— or, more precisely, lack of it — may be a principal factor.
terrorist activity. For example, terrorists in Afghanistan have
Wealthy countries may be widely resented by people from
sold opium for funding and relied on mountains for protection,
poorer countries, and thus become terrorist targets. This
while those in Colombia have used cocaine and the rain forest.
may be especially true when the rich country is seen as
Lastly, larger countries may have more trouble monitoring
engaging in “economic imperialism” by exporting its goods
potential terrorists, increasing the terror risk.
and culture to less prosperous parts of the world.
Abadie’s work suggests that there is no magic cure for
Also, poverty may create an environment where people,
the root causes of terrorism. Increasing political freedom in
unhappy with their own lots in life, turn to violence at home.
a country is a long and difficult process, and there are no
For instance, a number of studies have documented that
obvious policy responses to the problems raised by linguistic
poverty increases political strife, which can lead to civil war.
differences and geographic characteristics. Still, his research
Abadie finds that countries with lower incomes do in
may help us determine the places where terrorist activity
fact have higher terrorist risks. While these results may
is most likely to arise and to better focus our efforts in
seem to lend some credibility to the idea that poverty
preventing future attacks.
RF
breeds terrorism, the situation is more complicated.

S

Spring 2005 • Region Focus

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SHORTTAKES
BEAN BALL

The Designated Hitter
and Moral Hazard

B

edge that the mystery of the hitbatsmen differential has been
explained.
— DOUG CAMPBELL

atters in the American League
LAND OF THE ECONOMICALLY FREE
(AL) of Major League Baseball
have long faced the unpleasant
knowledge that they are 15 percent more likely to be hit by a
ccording to a new study
pitch than their National League
released by the Pacific
(NL) counterparts.
Research Institute (PRI), a marketA virtual cottage industry has
oriented think tank based in San
sprouted to explain the AL’s rate of
Francisco, Virginia stands as a
hit batsmen. The most accepted
“citadel of economic freedom in
conclusion is that the introducthe South.” The 2004 U.S. Economic
tion of the designated hitter (DH) Sammy Sosa of the Chicago Cubs recoils as a fastball
Freedom Index ranks Virginia as the
in the AL in 1973 created a moral shatters his helmet in 2003. Sosa now plays for the
third most economically free state
hazard problem. That is, pitchers Baltimore Orioles.
in the United States. No other
in the NL face a higher price for
Fifth District state placed in the
plunking batters because they, as batters themselves, can
top 10: South Carolina (13), North Carolina (24), Maryland
face retaliation for their errant pitches. Meanwhile, in the
(27), and West Virginia (32).
AL, pitchers almost never step into the batter’s box, since
Sally Pipes, president and CEO of PRI, describes the
designated hitters take their place at the plate. The conseEconomic Freedom Index as an “important tool, grounded in rigquences of a brush-back pitch are far less severe in the AL
orous statistical analysis, for measuring how friendly (or
than in the NL.
unfriendly) each state government is toward free enterprise
Another theory posits that NL pitchers go out of their
and consumer choice.” PRI’s study of individual states is
way not to hit their pitching counterparts because they’re
modeled loosely after existing research conducted on an
international scale, such as the Economic Freedom of the World
such awful swingers; hitting a pitcher is a waste because it’s
and the Economic Freedom of North America reports, published
so easy to get them out, statistically speaking.
by the Fraser Institute and others.
A recent contribution to the literature comes from John
Charles Bradbury and Douglas Drinen, professors at
To calculate index values, more than 140 variables were
Sewanee: The University of the South.
considered for each state, including everything from tax rates,
state spending, and income redistribution, to occupational
Overall, they agree that much of the difference between
licensing, environmental regulations, and wage laws.
the two leagues is attributable to AL pitchers’ lack of fear of
Ultimately, a statistical index linked to migration was adopted
retaliation. But Bradbury and Drinen plow deeper than any
to rank states in terms of economic freedom, because, the
others have ventured: They attempt an explanation for the
report explains, “migration is the purest expression of individnarrowing hit-batsmen gap during the 1990s — when, counuals responding to differences in freedom … People want to be
terintuitively, in four years there were more batters sent diving
free: they strive and work to be free, and search out locations,
for the turf in the NL than the AL. Their answer is twofold.
governments, and situations where freedom reigns.”
First, league expansion diluted the talent level in the NL
more than in the AL, which probably meant that more batThe study’s authors, Lawrence J. McQuillan, director of
ters were unintentionally hit by wild, inexperienced pitchBusiness and Economic Studies at PRI, and Robert E.
ers. Second, there was the 1994 establishment of the “douMcCormick and Ying Huang of Clemson University’s ecoble-warning” rule, requiring umpires to warn both teams of
nomics department, hope that the new Index will persuade
consequences after an obvious bean ball or attempt. That
people that there is a link between economic freedom and
matters because it “significantly raises the cost of retaliaeconomic prosperity. As McQuillan says, “It affects their
tion. If a pitcher hits a batter, he knows that retaliation will
bottom line, their pocketbooks — and it’s an appropriate
be very costly for the other team.” Thus, NL pitchers have
issue for policymakers to focus on.”
let themselves get a little wilder since 1994.
According to the report, “a 10 percent improvement in a
state’s
economic freedom score yields, on average, about a
And maybe now, for a few years at least, baseball
half percent increase in annual income per capita.” Or, to
wonks can sleep soundly at night, content in the knowl-

Virginia Ranks Third in
New Study

8

Region Focus • Spring 2005

PHOTOGRAPHY: AP/WIDE WORLD PHOTOS

A

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:11 PM

put it another way, the average national “oppression tax” per
year is 4.42 percent of an individual’s income, and the average money amount lost from restrictions on economic freedom per year is $1,161 — adding up to almost $90,000 over
a 40-year working life.
Still, the Index’s findings reveal several surprises. Kansas,
a relatively low-profile state, secured the top spot, while
California and New York — states renowned for being hubs
of commerce and activity — trailed at the rear, in 49th and
50th place, respectively. These results seem to suggest that
while economic freedom is important, it is not the only —
or even the most significant aspect — in determining the
success of a state’s economy.
— JENNIFER WANG
FACT OR FICTION?

Looking for the Social Security
Trust Fund

N

ews flash: Not only does the much-talked-about
“Social Security trust fund” exist, it is physically located in the Fifth District. But it’s not in Washington, D.C., as
you might suppose. It’s in West Virginia.
A spokesman at the U.S. Bureau of the Public Debt
sounds a bit weary talking about it. Ever since President
George Bush made reforming Social Security a centerpiece
of his second-term agenda, there’s been a surge in interest
about the fund. Media calls have been incessant.
The Bureau of the Public Debt is the government arm
that actually does the work of investing tax receipts, issuing
securities, and redeeming those securities at the request of
the Social Security Administration. And all that happens in
the bureau’s operations center in Parkersburg, W.Va.
To call it a “fund” is a bit misleading, the spokesman
admits. It consists of 215 sheets of paper representing securities held by the Old Age and Survivors Insurance and
Disability Insurance funds. This winter, those paper instruments together symbolized $1.7 trillion in securities issued
to the trust fund. As such, they’re not really the sort of cash
holdings you might intuitively think of when hearing about
the Social Security trust fund. They’re IOUs, but given that
they’re backed by the federal government, many people
claim they’re pretty much as good as real money.
The trust fund’s paper certificates are locked in a fireproof safe — which looks more like a filing cabinet than a
safe — in the Bureau of the Public Debt’s operations center
at the H.J. Hintgen Building in Parkersburg. Not that the
safe gets a whole lot of attention. It sits outside somebody’s
office. The papers themselves are merely outputs from a
standard office laser printer, signed by the division director
for federal investments.
The reason the 215 pieces of paper exist is because of
1994 legislation that established the Social Security
Administration as an independent agency. The law required
the Treasury Department, which runs the Bureau of the
Public Debt, to issue paper instruments to represent the
trust fund’s assets.

In the debate over overhauling Social Security, the
significance of the fund has gained new importance. Official
projections say that by 2017, the government will have to
start tapping into the fund to fulfill its payment obligations
to retirees. By 2041, the funds will have been used up.
And presumably, the safe in Parkersburg will no longer
contain those pieces of paper now ostensibly worth trillions
of dollars.
— DOUG CAMPBELL
ONLINE BANKING

Customer Satisfaction Rises, But Privacy
Concerns Remain

W

ho would have thought 10 years ago that paying bills
and monitoring account balances would be only a
mouse-click away? It’s taken a while, but more and more
banking customers have moved from standing in line at the
bank to doing business online in their home.
Forbes.com and the consulting firm ForeSee Results
recently teamed up to release their second online banking
study. They wanted to find out how comfortable customers
are in conducting transactions online, and how banks might
be able to increase the size of this market.
Overall, the report showed an increase in customer satisfaction, with a rise of 5.5 percent since the previous summer
2003 study. This is important because, according to the
study, “satisfied” online customers are almost 40 percent
more likely to purchase additional services. The rise in satisfaction might be attributable in part to effective marketing.
In general, customers are happier because online banking is becoming easier. The site needs to be relatively painless to navigate in order for customers to easily set up bill
payment options, for instance. The reward for banks that
create such sites is that satisfied customers tend to feel more
“loyal” toward them. Also, online banking sites are often
cheaper to maintain than traditional bricks-and-mortar
banking establishments.
Though customer satisfaction has risen since the first
study two years ago, certain challenges remain. Some sites
remain stubbornly user-unfriendly. Privacy also remains a
big obstacle with potential online bankers, who worry about
the security of their personal information. Existing customers, however, feel comfortable with how banks manage
confidential information. Improved education of the public
on these concerns may help, the study says. In addition,
banks must compete with other third-party payment outlets
for the business of more savvy online consumers. Threequarters of respondents reported paying bills online through
a source other than their own bank.
In the end, the greatest challenge facing banks is to get
more potential customers online, and then keep them there.
Those people who feel comfortable doing business on the
Internet have generally availed themselves of online banking
opportunities. But this group makes up only 25 percent of all
banking customers. That leaves a huge untapped market for
banks to serve.
— JULIA R. TAYLOR

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homeward
bound
But certain markets in the Fifth District aren’t producing
homes and apartments that working families can afford
BY CHARLES GERENA

10

Region Focus • Spring 2005

ashington, D.C., radio stations reach far beyond the
borders of the nation’s
capital. Their traffic reports provide
vital guidance to drivers commuting
from the outskirts of the metro area,
from Charles County in southern
Maryland (28 miles from downtown
Washington), to Fredericksburg in
central Virginia (52 miles away), to
Jefferson County in the Eastern
Panhandle of West Virginia (73 miles).
Most Washington workers live outside of the city, driving half an hour, on
average, each way. Other suburbanites
and rural residents throughout the
Fifth District are well acquainted with
interstate travel, working in one place
and living somewhere else miles away
in order to earn a better salary, benefit
from a lower cost of living, or both. In
the U.S. Census Bureau’s 2003 population survey, about 2.6 million of the 40
million people who relocated did it
because they were looking for a
cheaper place to live.
There certainly isn’t a lack of residential development — housing construction has been rising for years in
both metro and nonmetro areas. The
problem is the type of development
that has occurred in certain housing
markets. These markets emphasize
larger, pricier homes for purchase
over smaller homes and multifamily
rental units that are less expensive to
build and sell.
“In most places, the new construction is going for the high end of the
market,” says C. Theodore Koebel,
director of the Center for Housing
Research at Virginia Tech. “We’re not
building for the middle of the market,
and we’re certainly not building anything for below the middle.” As a
result, people at or near the median

W

PHOTOGRAPHY: MEL CURTIS/GETTY IMAGES

Housing markets work just fine for most people.

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

income cannot afford the medianpriced home or apartment in a growing
number of communities, while those
further down the income scale are feeling the squeeze even more. “Home
prices have moved closer to the median,
whereas their incomes have not moved
up toward the median,” adds Koebel. “If
anything, they have moved further away
from the median.”
Housing affordability has long been
an issue for the poor and those on
fixed incomes. People at the bottom
are the least able to respond to price
increases or relocate, and they have so
few financial resources that it’s hard to
build shelter cheap enough for them to
afford. Now, mounting housing costs
are outrunning the earnings of working families as well, taking bigger bites
from the paychecks of retail store
employees, teachers, nurses, and other
low- to moderate-income workers.
Not adjusting for inflation, data from
the Office of Federal Housing
Enterprise Oversight and the National
Association of Home Builders shows
that house prices appreciated 78 percent from 1994 to 2004. National
personal income increased only 64
percent during the same period.
In other words, affordable housing
is a concern for wider segments of
the U.S. population. The number of
middle-income families devoting
more than 30 percent of their income
to housing grew from 3.2 million in
1997 to 4.5 million in 2001. This 41 percent increase exceeds the population
growth in this income group.
What is behind the growing divide
between what people can pay and
what housing sells for? The leading
candidate on the supply side of the
market equation is the collision of
rapid population growth with constrained residential development in
regions like Northern Virginia. “The
region is pretty heavily regulated in
terms of land use, and that’s true of the
Washington metropolitan area in general,” says Richard Green, director of
George Washington University’s
Center for Real Estate and Urban
Analysis. “When you have limits on
supply, it means that increases in

demand will show up in prices rather
than in quantity.”
Opening the door to more development wouldn’t necessarily provide
affordable options for all — it doesn’t
address demand-side factors that put
housing outside of people’s grasp —
but it might reduce the number of
people in need. Then, government
agencies and nonprofit organizations
could tackle housing affordability in a
more targeted manner.

Where’s the Problem?
When reporters and researchers
examine housing affordability in a
community, they often refer to the
share of income that residents spend
on putting a roof over their heads. The
U.S. Department of Housing and
Urban Development (HUD) considers
an apartment or home to be unaffordable when expenses like rent, mortgage payments, and property taxes
exceed 30 percent of earnings, since
that leaves an inadequate amount of
money to pay for other necessities like
food, clothing, and health care.
For example, the median annual
salary of a kindergarten teacher in the
Washington, D.C., metro region is
$48,396, according to surveys conducted by Salary.com. Thirty percent
of that income would be $14,519, or
$1,210 a month. Thus, teachers earning
at the median could qualify for a
$155,000 house, assuming they can get
a 30-year loan at a 5.75 percent fixed
interest rate and put down 10 percent
of the price toward the down payment
and closing costs. However, the D.C.
region’s median home price was
$340,000 in the fourth quarter of
2004, and it hasn’t been near the
$155,000 mark since 1998.
Using income-cost ratios to gauge a
neighborhood’s housing affordability
doesn’t take into account individual
preferences, though. “Some households may consider their housing a
good deal even if they spend more
than 30 percent of their income on it,”
noted Ron Feldman, an assistant vice
president at the Federal Reserve Bank
of Minneapolis, in an August 2002
working paper. “[They] may prefer to

live in amenity-rich locations, with
nice weather, for example. In such
locations, the greater demand for
housing would boost its cost.”
Moreover, low-income people may
make short-term sacrifices in their
budgets so that their children can
grow up in safer neighborhoods with
better schools. Others, especially
young people, may initially tolerate
high housing costs relative to income
if they expect their incomes to rise
over their lifetimes. Economists say
that such smoothing of consumption
is common — people plan their present consumption based upon what
they observe today and what they
expect for the future.
Using income-cost ratios also doesn’t
take into account the availability of
credit. That’s why Howard Savage, a
researcher at the Housing and
Household Economic Statistics
Division of the U.S. Census Bureau,
includes household assets in his
reports on home affordability. “If
they had to, people could sell some of
their financial assets to buy a house,”
he says, or they can borrow against
them. Therefore, when the cost of
credit is cheaper, “people can afford to
pay more. When interest rates get
higher, which they will someday, they
will be able to pay less than what they
can now.”
No matter how it is measured,
housing affordability isn’t a problem
confined to notoriously expensive
cities like New York or San Francisco.
“People with critical housing needs
[those who pay more than 50 percent
of income on shelter] are more likely
to be found in the Northeast and the
West, but it’s a growing problem in the
South and the Midwest,” notes
Barbara Lipman, research director at
the Center for Housing Policy in
Washington, D.C.
Affordability can become an issue
in any community where economic
prosperity and residential development aren’t in sync. For example, parts
of the Baltimore region have done well
economically, but housing development hasn’t occurred in the same
places, according to John Kortecamp,

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Moving Up
In southern Maryland, there isn’t a large supply of
older housing stock to redevelop into affordable
homes. More than half of the region’s owneroccupied units were built in the last two decades
in response to population growth.
100
90

% of Homes Built, 1980 - 2000

PERCENTAGE

OF HOMES

80
70
60

63.8

50

55.2
51.8

40

37.8

30
20
10
0

Calvert
County

Charles
County

,
St. Mary s
County

Maryland

SOURCE: U.S. Census Bureau

executive vice president and CEO of
the Home Builders Association of
Maryland. “The demand is not being
met where the jobs are being created.”
The city has thousands of vacant
homes that could be redeveloped or
torn down to make room for affordable housing. Yet crime and underperforming schools have resulted in
population losses in these deteriorating neighborhoods, leaving behind
lower-income residents who don’t
earn enough to pay even the most
modest housing costs.
Meanwhile, smaller homes and multifamily units aren’t being built outside
of the city, where higher-income people have moved, because of community
pressure to reduce density. As a result,
“Every time a new project opens up,
the prices get bid up substantially,” says
Kortecamp. Waterfront communities
like Fells Point and Locust Point are
being redeveloped for high-end buyers
to take advantage of unmet market
demand.
The Charlotte, N.C., metro area
has experienced broader economic
and residential development than
Baltimore has. John Byers, president of
12

Region Focus • Spring 2005

the Charlotte Regional Realtor
Association, describes a flurry of
new housing in the city’s downtown,
especially condominiums, and redevelopment of older neighborhoods near
downtown in response to the influx of
new residents.
This rising demand has driven up
prices. “If you are looking for the most
bang for your buck, you may not live
downtown,” notes Byers. But more
affordable options are available within
a short drive from Charlotte’s employment centers. He knows of several
builders producing smaller, simpler
homes for working families.
On the opposite end of the affordable housing spectrum is Washington,
D.C. The metro region’s economic
growth has been strong, but the cost
of residential development is so high
in Virginia counties like Loudoun and
Fairfax and Maryland counties like
Charles and Calvert that only expensive projects go forward. The result is
people driving an hour or more to
West Virginia or central Virginia to
find more affordable options.

The Supply Side: What Sellers
Can Build
What has driven up the cost of
residential development in these
counties and in other communities,
pushing housing costs beyond the
financial means of some workingclass families? Joseph Gyourko, a
professor of real estate and finance
at the University of Pennsylvania,
believes that land is the culprit.
“Construction costs have gone down
over the last 20 years,” while land
costs have climbed in certain places.
One would expect that in areas
with strong demand for housing,
the marginal cost of acquiring land
for development would increase as
available space becomes scarcer. In
recent papers, Gyourko and economist Edward Glaeser at Harvard
University have argued that manmade scarcity — namely zoning rules,
building codes and other regulatory
constraints on residential development — is a bigger factor.
“If demand is going up in areas

where you have restricted the ability
to develop, you’re going to get very
high land prices,” explains Gyourko.
This makes it harder to build less
expensive housing. “[Builders and
developers] want to spread the fixed
costs of those restrictions over a
bigger base, so [markets] end up tilting
toward a higher-value product.”
Although most methods of regulating residential development add to
housing prices, they have been utilized
since the early 20th century to meet
legitimate policy goals. For example,
the outcry over poor families living in
crowded, substandard tenements
prompted lawmakers in New York and
other cities to require that residential
buildings have larger rooms, indoor
plumbing, external windows, and
separate hallways.
“The market would create some
serious problems without some level
of land-use planning,” argues Virginia
Tech’s Theodore Koebel. “You might
not have efficient use of certain
locations.”
Regulation of residential development also stems from a community’s
desire to discourage the construction of
smaller homes, multifamily rental properties, and manufactured housing like
mobile homes. Neighbors fear that
these less expensive options will lower
property values, even though numerous
studies have cast doubt on this claim.
For instance, Charles County
changed its land-use regulations in
the late 1990s and early 2000s to
address concerns over the type of
housing being built to meet demand,
according to the county’s community
development housing plan drafted
in 2004. Officials increased the
minimum size of townhouses and
single-family, detached homes to
1,650 square feet, and imposed
architectural standards such as
requiring the use of brick exteriors.
“The idea was to ‘upscale’ the housing
styles,” says Robert Tourigny,
housing division administrator of
an anti-poverty group called the
Southern Maryland Tri-County
Community Action Committee
(SMTCAC). In the process, the new

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

rules also upped development costs.
Communities also oppose dense
development out of concern for
crowded roadways and schools. Once a
community is built out with relatively
sparse, single-family development, it is
difficult to rezone it to meet rising
demand. SMTCAC lobbied Calvert
County officials to change the zoning
in its town centers to allow mixed-use
development with housing above
storefronts. “The county commissioners looked at us like we had two heads
and were from Mars,” says Tourigny.
With no land available to meet
demand, development often spills
into neighboring communities.
“Those areas get hit with a lot of
major development all of a sudden
and are completely unprepared for it,”
notes Koebel. In turn, local officials
may impose their own land-use
restrictions.
This scenario has played out in the

Washington, D.C., area — restrictions
in Fairfax County pushed demand
westward to Loudoun County, which
implemented slow-growth measures in
1999 that pushed development farther
west into Jefferson County, W.Va. (In
March, the Virginia Supreme Court
overturned Loudoun’s slow-growth
regulations, much to the satisfaction
of the numerous property owners and
developers who had protested the
measures.)
Regardless of the motives, “landuse planning has to reasonably anticipate what future growth is going to be,
and plan for that growth,” says Koebel.
When it leaves a lot of demand for
housing unmet, prices can skyrocket
and affordable options can evaporate.

The Demand Side: What Buyers
Can Pay
Of course, supply-side factors aren’t
alone responsible for driving up the

cost of residential development. Things
also have been happening on the
demand side. As long as some buyers
and renters in a community are willing
and able to pay higher prices, the market as a whole will bear those prices,
even if some people can’t.
Often, newcomers that aren’t economically tied to a community distort
housing prices. For example, workers
from flourishing suburbs may migrate
to urban and rural communities where
their incomes are relatively high and
the cost of living is relatively low so they
can get the amenities they want. As a
result, housing prices will rise, since
newcomers will still consider them relative bargains. Meanwhile, many natives
may be unable to keep up with rising
prices and property taxes because there
are few job opportunities around.
Back in southern Maryland, population growth has come from workers
migrating from the District and

The Push to Homeownership
Enlarging the ranks of homeowners has been viewed as a way to
bring stability to the finances of communities and individuals. At
the same time, though, the push toward homeownership may be
contributing to affordability problems in various housing markets.
First, the mortgage interest deduction and the exclusion of
home price appreciation from capital gains taxes are only available
to those who earn enough income to itemize deductions on their
tax returns. Moreover, both tax breaks increase with the size of the
house. Therefore, the people who benefit the most have higher
incomes and own larger homes, thus orientating housing markets
away from lower-income buyers looking for smaller properties.
Second, local officials and communities usually view converting multifamily rental units into for-sale condominiums or
replacing them with single-family homes as supporting entrylevel homeownership and higher property values. But conversions also reduce the supply of rental units. This helps apartment markets avoid a period of oversupply that requires owners
to reduce their rents to attract tenants, which is good for apartment owners and developers. It’s not so good for tenants
because they never see prices fall and they are left with fewer
affordable options.
So what if there is less rental housing available? In general,
homeownership may not be appropriate for everyone. “With
mortgage delinquencies and foreclosures at record levels … millions of poor families might have been better off today had they
not chosen to purchase a home,” noted an article in the
January/February 2003 issue of Shelterforce, a publication of the

National Housing Institute. “Lower-income families are more
likely to borrow against the equity in their home, often at high
rates, diminishing any accumulated wealth.” And, they are more
vulnerable to downturns in the real estate market since more of
their wealth is tied up in their homes.
At one time, renting an apartment was something young couples did while saving money to buy a house or to avoid dealing
with the overhead of homeownership. Now, there is a bias against
renters. They are perceived as people with financial difficulties
who could bring trouble. As a result, communities often oppose
the approval of rental housing.
Meanwhile, developers seem less interested in serving renters
on the low end of the income scale. For example, Gumenick
Properties decided that three of its rental properties in Henrico
County, Va., were “worn out” and “nearing the end of its useful
economic life,” according to spokesman Edward Crews. So, the
Richmond-based firm has been demolishing the properties and
replacing them with higher-quality apartments and townhomes,
most of which are priced much higher than the original rental
units were. In addition, it has built high-end for-sale units on
these properties.
Gumenick’s strategic plan reveals why the company chose this
course. “The costs of servicing conventional construction loans
and paying for normal operations, coupled with the extremely low
profit margins for low-income houses, would force the company
either to produce substandard structures or to lose money on the
project. Neither alternative is acceptable.”
— CHARLES GERENA

Spring 2005 • Region Focus

13

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

Northern Virginia, as well as military
and civilian workers transferred to
Patuxent River Naval Air Station in St.
Mary’s County as part of the Pentagon’s
recent base realignments and closures.
Contract workers with defense firms
have also moved to the region. All of
these people have brought their higher
wages with them, along with a demand
for higher-quality housing. “It really
tightened the market to the point
where local service workers just couldn’t
find housing,” Tourigny says.
Jefferson County is in the same
predicament. Out-of-towners have
transformed a traditionally agrarian
community with some light industry
into a middle-class refuge that stands
in stark contrast with the majority of
West Virginia. “There are more young
families with larger incomes and college educations moving into the
Eastern Panhandle,” says Topper
Sherwood, a consultant for the regional
office of Habitat for Humanity. “The
bad news is that they are, by and
large, linked to jobs in and around
Washington.” Today, 50 percent of
Jefferson’s residents commute outside
of the county’s borders.

In Search of Cheaper Housing
Housing affordability isn’t just a problem for the
poor. Middle-income workers have had to move
miles away from the central core of the
Washington, D.C., metropolitan area to find
housing that doesn’t overwhelm their budgets.
ey

el

rke

Maryland
Montgo

mery

Loudoun

WASHINGTON, D.C.

W

c
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e

S

1 - 19%

20 - 39%

Charles
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y
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ia
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Virginia

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Cla

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es

Be

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.M

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40 - 49%

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50 - 60%

Percentage of Middle-Income Households That Pay
More Than 30% of Earnings on House-Related Costs
NOTE: Middle-income households were those earning between
$35,000 and $49,999 a year.
SOURCE: U.S. Census Bureau, 1999

14

Region Focus • Spring 2005

Well-heeled retirees, investors in
seasonal housing, and second-home
buyers can have a similar effect when
they enter housing markets. Residents
in Charleston, S.C., complain about
the impact of “drive-by neighbors,”
wealthy people who have been renovating historic properties into coastal
retreats. Their demand has worked
hand in hand with local restrictions on
new development to drive up property
values beyond the reach of longtime
residents.
This contributes to a lack of “filtering.” Housing experts expect people to
move up to better homes in more
desirable communities as their financial status improves, leaving behind
older homes in less desirable areas or
rental units that others with lower
incomes can move into. However,
refugees from hot housing markets
can rapidly bid up prices as they
compete for these latter properties.
Filtering may fail to occur for other
reasons. Some homeowners may not
want to upgrade. They may live in a
nice place and have no mortgage to
pay. Or, they may be unable to afford a
move, even if they sell their home for a
tidy profit, because housing prices are
rising sharply.
Another demand-side factor that
has supported higher housing costs is
the wider availability of cheap credit.
“Prices have gone up very dramatically
in many areas [but] low interest rates
have significantly dampened the effect
of those increases,” says Virginia Tech’s
Koebel. Also, “we’ve got a tremendous
amount of new mortgage products”
that give borrowers more flexibility
and allow them to have a higher loanto-value ratio.
Still, not everyone qualifies for favorable mortgages, if any. And credit won’t
be cheap forever. Real estate economists
expect mortgage rates to rise from 45year lows later in 2005, affecting housing
affordability in the future.
Finally, while median earnings have
kept up with housing costs in the
aggregate, not everyone in a community earns the median. Lower-skilled,
lower-income workers have experienced slower wage growth than those

who are at the median and above,
excluding noncash government benefits. Also, certain occupations have
suffered from stagnant wage growth
at various times, including nursing,
teaching, and social work.

Below the Median
For most of American history, markets met the demands of lowerincome people seeking housing,
although not always in ways that
everyone considered socially acceptable. In cities, boarding houses, lowrent apartment buildings, and singleroom occupancy hotels were available
for people climbing from the bottom
rungs of the economic ladder. Owners
of commercial buildings would add
apartments on their upper floors,
while immigrant families would build
simple homes like the brick bungalows of Chicago or the Polish flats of
Milwaukee.
Many of these options disappeared
in the 20th century when local officials, with the help of federal funding,
tore down blighted areas as part of
broad urban renewal projects. To fill
the need for low-cost housing, governments began building their own.
The construction of federal public
housing began in the 1930s and continued through the ’70s. But by the
1990s, this model was widely considered a failure because it removed the
incentive for private parties to come
up with affordable alternatives. It also
concentrated poorer people into
high-rise buildings and sprawling lowrise complexes, many of which were
mismanaged and riddled with criminal activity. Now, governments on all
levels have shifted gears by spurring
others to develop and operate affordable housing for those people whose
incomes fall below the median.
Some localities and states offer
property tax breaks to developers,
usually nonprofit groups, in exchange
for building affordable projects and
maintaining their pricing for a minimum number of years. (HUD offers
Low Income Housing Tax Credits that
provide a 10-year reprieve from federal
taxes for investors in affordable hous-

ing.) Others create housing trust funds
to finance affordable housing, using
development fees and other taxes as
sources of revenue, or provide belowmarket construction loans to reduce
development costs. Banks also provide
such loans to fulfill their legal obligation to meet the credit needs of all
areas from which they draw deposits.
But such efforts to subsidize housing development carry risks. “Any
financing that distorts the market creates some problems,” says Moises Loza,
executive director of the Housing
Assistance Council, a Washingtonbased nonprofit group that examines
affordable housing issues in rural areas.
Some economists say that subsidized
development can discourage private
investment in building new housing or
keeping existing units in the market.
Another approach is to impose
inclusionary zoning on a community.
Pioneered in Montgomery County,
Md., 30 years ago and used throughout
the Washington, D.C., metro region,
this regulation requires a new residential project to include units that are
affordable to people at a particular
income level (usually a percentage of
median income) for a specified period
(often 10 years or more).
To help prevent the developer from
raising the prices of the other units to
make the project’s numbers work,
Montgomery and other municipalities
provide “density bonuses” that allow
more units to be built than the project’s zoning normally permits.
Developers may also get fast-track
permitting, fee waivers, or exemptions
from growth controls.

A commuter bus carries Charles County,
Md., residents from this Park and Ride
to their jobs in Washington, D.C.,
every morning.

Inclusionary zoning has succeeded
in creating additional supply in
some areas — more than 10,000
affordable units were produced in
Montgomery County between 1974
and 2001. However, if the factors
that are driving up home prices aren’t
dealt with separately, even the affordable units that the builder was
required to construct will go up in
value, says Howard Savage at the
Census Bureau. When the units are
open for purchase by any buyer, they
will likely be sold at market prices,
eroding the supply of affordable housing. “It doesn’t get turned over to
other people who are poor. It gets renovated and the people who have high
incomes buy it,” Savage says.
Ultimately, lowering the bar for residential development will likely be the
most effective way to increase the supply of housing to include units for lowand moderate-income households.
That would require a slowing or reversal of policies meant to curb sprawl
and guard property values. Then, some
form of rent subsidization, like HUD’s
Housing Choice vouchers, could be

provided for the lowest income families who still couldn’t afford housing.
Also, if the real concern is with people
devoting too much of their incomes to
housing, the Minneapolis Fed’s Ron
Feldman suggests that governments
provide direct assistance to help cover
other basic needs.
Meanwhile, working families are
finding ways to cope. For one thing,
they may decide to spend more on
housing at the expense of other things
in the household budget. In extreme
cases, this could mean paying the phone
bill late or skimping on a grocery trip.
Usually, it means foregoing some things
in the short term in order to meet their
long-term housing needs.
Others have saved money by purchasing manufactured homes. Once
epitomized by a flimsy trailer parked
on cinderblocks, this category of
housing has vastly improved in quality
while remaining cheaper to produce
and purchase than site-built homes.
As a result, many rural residents have
used this route to homeownership —
North Carolina, South Carolina, and
West Virginia are among the five
states in the nation with the highest
share of housing units that are built
off-site.
For those who are prepared to give
up their neighborhood ties and shoulder
the costs of relocating, families can
search for affordable housing elsewhere.
“People [who] are paying large amounts
of their income for housing … reach a
point where they can’t do that anymore
and they move,” says Savage. It is this
migration that has shaken up so many
housing markets across the country. RF

PHOTOGRAPHY: CHARLES GERENA

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

READINGS
Collins, Michael, David Crowe, and Michael Carliner. “Examining
Supply-Side Constraints to Low-Income Homeownership.” Working
Paper LIHO.01-5, Joint Center for Housing Studies, Harvard
University, August 2001.
Crowe, David, et al. Where is Workforce Housing Located? A Study of the
Geography of Housing Affordability. Washington, D.C.: National
Association of Home Builders, 2004.
Feldman, Ron. “The Affordable Housing Shortage: Considering the
Problem, Causes, and Solutions.” Federal Reserve Bank of
Minneapolis Banking and Policy Working Paper 2-02, August 2002.

Glaeser, Edward L., Joseph Gyourko, and Raven E. Saks. “Why Have
Housing Prices Gone Up?” National Bureau of Economic Research
Working Paper no. 11129, February 2005.
Lipman, Barbara. Paycheck to Paycheck: Wages and the Cost of Housing in
the Counties, 2004. Washington, D.C.: Center for Housing Policy, 2004.
Treskon, Mark and Danilo Pelletiere. Up Against a Wall: Housing
Affordability for Renters. Washington, D.C.: National Low Income
Housing Coalition, 2004.
Visit www.richmondfed.org for links to relevant sites and supplemental
information.

Spring 2005 • Region Focus

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Economists believe as much as 10 percent of
the U.S. economy is “underground.”
Is that such a bad thing?
BY DOUG CAMPBELL

H

16

Region Focus • Spring 2005

and 20 percent of GDP. At the midpoint, this would be about $1.5 trillion
a year.
Broadly defined, the underground,
gray, informal, or shadow economy
involves otherwise legal transactions
that go unreported or unrecorded.
That’s a wide net, capturing everything from babysitting fees, to bartering home repairs with a neighbor, to
failing to report pay from moonlighting gigs. The “underground” label
tends to make it sound much more sinister than it really is.
Criminal activities make up a large
portion of what could be termed the
total underground economy. Many
studies have been done on the economics of drug dealing, prostitution,
and gambling. But because money
from crime is almost never recovered,
many policymakers are more interested in portions of the underground
economy that otherwise would be
legal if not hidden from authorities.
Things like shoveling walks.
Despite its intrigue, the informal
economy’s importance and consequences remain in debate. The reason:
“You’re trying to measure a phenomenon whose entire purpose is to hide

itself from observation,” says Ed Feige,
an economist at the University of
Wisconsin.
This uncertainty poses problems
for policymakers. Without knowing
the precise size, scope, and causes of
the underground economy, how can
they decide what — if anything — to
do about it?
Was the man who shoveled my walk
engaging in a socially positive or negative activity? Was I? Suffice it to say,
some economists have dedicated their
entire careers to answering questions
about the underground economy —
and still there is nothing close to a consensus about its size or description.

Elusive Definition
Friedrich Schneider, an economist at
the Johannes Kepler University in
Linz, Austria, defines the informal
economy as: “All market-based legal
production of goods and services that
are deliberately concealed from public authorities for the following reasons: 1) to avoid payment of income,
value added, or other taxes 2) to avoid
payment of social security contributions 3) to avoid having to meet certain legal labor market standards,

ILLUSTRATION: AILSA LONG

ere is the brief, unremarkable
story of how I recently came
to participate in the underground economy:
Midafternoon on the iciest day this
past winter, a man knocked at my
front door. “Shovel your walk?” he
asked. “Only $5.”
Outside, it was a bone-chilling
15 degrees. “Sold,” I said. A halfhour later I handed over a five-dollar
bill and thanked him for saving me
the trouble.
Officially, this was an unofficial
transaction — off the books, with no
taxes paid or safety regulations followed. (At least, I assume this hired
hand didn’t bother to report that
income or register with the proper
authorities.) As such, it was technically illegal. And, of course, it’s the sort of
thing that happens all the time.
The size of the official U.S. economy, as measured by Gross Domestic
Product (GDP), was almost $12 trillion in 2004. Measurements of the
unofficial economy — not including
illegal activities like drug dealing and
prostitution — differ substantially.
But it’s generally agreed to be significant, somewhere between 6 percent

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

such as minimum wages, maximum
working hours, safety standards, etc.,
and 4) to avoid complying with certain administrative procedures, such
as completing statistical questionnaires or other administrative forms.”
In Schneider’s latest study, the U.S.
informal economy — or “shadow
economy,” as he calls it — is pegged at
8.4 percent of GDP. His estimate was
derived using a combination of two
estimation methodologies: one that
measures demand for currency and
another a mathematical model that
seeks to consider multiple causes of
the underground economy as well as
its multiple effects.
Other approaches include examining
the discrepancy between spending and
income, as claimed in tax filings; the gap
between the official and actual labor
force; and comparing electricity consumption with reported economic
activity. Using a variety of methods, even
the keepers of the national accounts,
which produce GDP figures, try to tally
the impact of the unreported economy
in estimating the official economy.
Ed Feige, the University of
Wisconsin economist, favors methods
that study cash stocks and flows. His
research focuses on the “unreported
economy,” which involves transactions whose purpose is to evade taxes.
His latest work puts the 1993 unreported economy at $700 billion.
None of these approaches is perfect or precise. “To some authors, the
whole exercise is doomed to failure,”
writes English economist Huw Dixon
in a 1999 introduction to a series of
journal articles about the underground economy. “If we have no direct
measure, then indirect measures are
likely to be no better than guesstimates, which should be taken at best
as interesting novelties.”
Given the level of doubt about the
size of a nation’s overall underground
economy, it’s no wonder that regional estimates are hard to come by. The
Internal Revenue Service studies tax
evasion on a national level and in
1998 quantified revenue losses at
$195 billion — most of that believed
to be the result of the transactions

taking place in the underground
economy. But there exists no stateby-state study of tax evasion, largely
because politicians representing
their districts don’t want that kind of
information released.
This makes it risky to attempt
approximations of a region’s underground economy. If you trust
Schneider’s work, you might make a
simple extrapolation: The Fifth
District’s economy is valued at about
$1 trillion a year, as calculated by
adding up each “gross state product.”
That’s about 10 percent of the overall
U.S. GDP. So if the Fifth District’s
black market is in proportion with
Schneider’s estimate for the rest of the
nation’s, then we can estimate that the
region’s underground economy is
worth about $84 billion.
Whether the informal economy is
more active in rural or urban settings
also remains to be settled. Shanna
Ratner, an economic development
consultant who studies informal
economies in rural settings, thinks
they’re close to equal. Conditions like
poverty and economic immobility —
considered likely features of many
informal economies — prevail in both
inner-city and back-country environments. Farmers looking for a competitive edge are just as likely to hire illegal
immigrants as inner-city warehouse
managers.
Observers like Ratner are reluctant
to judge those participating in informal economies, be they employers or
hired hands. “I don’t think it is in itself
either a good thing or a bad thing,”
Ratner says. “It has to be viewed in
context. When the informal sector
results in activities that strengthen
social capital, because they’re relationship-based, one could argue that’s a
good thing. When the informal sector
activities are illegal because they’re
harmful … then that’s arguably a bad
thing.” In a 2000 paper about the
informal economy, Ratner cited
instances of home-based production
(everything from arts and crafts to
laundry) as a crucial means to “close
the gap between wages and human
needs and wants.”

Looking for the Underground
To get a better idea of how a full-fledged
underground economy operates, I went
to Floyd, Va. On paper, Floyd looks like
just the sort of place where a rural-style
informal economy should be thriving.
Here is an Appalachian community with
a rich history of barter. Writing about
life just across the border in West
Virginia, historian Paul Salstrom
described it this way: “Appalachia’s main
economic anomaly was that distributive
relations remained less monetized
there; they remained composed more of
bartering and borrowing.” A short drive
away is Abingdon, Va., home of the
“Barter Theatre,” founded in the 1930s
as a place where local farmers could
swap their crops for admission to a play.
There is no interstate coursing
through Floyd. Its downtown is crisscrossed only by two-lane highways.
Median family income in the county is
$38,128 compared with $54,169 among
all Virginia counties. Even in the relatively poor New River Valley, Floyd
County stands out with its low taxable
sales base, bank deposits, and high
poverty rate. There has been a flight of
manufacturing employers, creating
more unemployed and underemployed
people seeking work wherever they
can get it, even if it’s off the books.
David Rundgren, executive director of the New River Valley Planning
District Commission, says on-the-side
economies are part of Floyd’s culture.
“Throughout history these folks have
been fairly independent and trading
work with each other,” Rundgren says.
For me, the big draw to this town
were “Floyd Bucks” — Floyd’s own
currency. Officially called the “Floyd
Hours,” blue-colored bills were printed in 2002 by a nonprofit group whose
aim was to “make a statement in
support of our local economy,” says
Dawn Shiner, founder of Floyd’s
community currency effort. A “onehour” bill is pegged to an estimated
value of one hour’s worth of labor,
or $10. There are also quarter-hour
bills valued at $2.50.
Informal economies do not require
their own currencies. Indeed, most
transactions in the informal economy

Spring 2005 • Region Focus

17

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Locals call them “Floyd Bucks,” but these bills
are officially called Floyd Hours. A small group
of residents in Floyd, Va., printed their own currency as part of an effort to keep business local.

probably are done in official U.S.
currency, and those conducted in alternative currencies are supposed to be
subject to taxes. And what I actually
found in Floyd was an environment
not unlike any small town across the
United States: Sure, people are independent and will trade goods and
services when it suits them, but U.S.
currency and regulated work far
eclipse the underground economy.
At the Harvest Moon, which locals
refer to as the health food store, owner
Margie Ryan says that in principle, she
likes to barter whenever possible. In
practice, it’s not so easy, which is why
she stopped accepting “Floyd Bucks.”
“It’s part of the overall culture of
working together to get things
done,” Ryan says. “But everybody
wanted to use those bills here, and
I don’t need so many labor hours.
I need to pay my bills.”
A quick survey of downtown retail
establishments in Floyd revealed similar sentiments. From the hardware
store to an art gallery, the answers were
the same. A hostess at Mama Lazardo’s
Pizza summed it up: “I have ’em, but
I have no way to spend ’em.”
Shiner modeled the Floyd Hours
after upstate New York’s Ithaca Hours,
the most successful community currency in the United States. More than
$105,000 in Ithaca Hours have been
issued since 1991, and an estimated
400 businesses in the region accept
them. “Community currency systems
are excellent tools to help revitalize
18

Region Focus • Spring 2005

local economies since they encourage
wealth to stay within a community
rather than flowing out of it,” Ed
Collom, a University of South Maine
professor, wrote in a recent article.
Floyd Hours haven’t enjoyed nearly
that level of success. Shiner guesses
that only $500 in Floyd bucks was
ever printed. Originally, there was a
directory of some 20 business establishments that accepted them; today,
none are known to.
“In this culture it’s hard to expect
any of us to just use local currency,”
Shiner says. “It’s a supplemental thing.
It’s a statement saying ‘I believe in
my region,’ a way to facilitate more
exchange and a way to help others
know what’s available in our region.”
The fact is, Floyd’s currency, like its
informal economy, is hard to detect.

The Other Path
Those concerned about underground
economies point to nightmare scenarios
like the one captured in Hernando de
Soto’s book The Other Path, which
described how burdensome government regulations in Peru spawned an
underground economy that encompassed 38 percent of GDP.
Enrique Ghersi, de Soto’s coauthor in Spanish-language versions of
the book, defined this informal economy as entailing “activities that do not
intrinsically have a criminal content,
but must be carried out illicitly, even
though they are licit and desirable
activities for the country … Thus,
from an economic point of view,
the most important characteristic
of informal activities is that those
directly involved in them as well as
society in general benefit more if the
law is violated than if it is
followed.”
Almost 20 years after describing
Peru’s plight, economists generally
agree that the shadow economy is
worse in developing nations, whose
webs of bureaucratic red tape and corruption are notorious. For instance,
Schneider in 2003 published “shadow
economy” estimates (defined broadly
as all market-based, legal production
of goods and services deliberately

concealed from the authorities) for
countries including: Zimbabwe, estimated at a whopping 63.2 percent of
GDP, Thailand’s at 54.1 percent, and
Bolivia’s at 68.3 percent. Among former Soviet bloc nations, Georgia led
the way with a 68 percent of GDP
shadow economy, and together those
nations had an average 40.1 percent of
GDP underground. This contrasts
with an average of 16.7 percent among
Western nations.
Some of Schneider’s estimates of
the size of the underground economy
are controversial; critics say that he
has jumbled different definitions of
the underground economy in his estimates and sometimes not matched
measurement methods, thus making
comparisons less meaningful. But few
quibble with his reasons for paying
attention to the underground:
• If it’s growing, it may be a “reaction
of individuals who feel overburdened
by the state.” As a result, they choose
to dodge the taxes or safety regulations
or licensing requirements that the state
imposes, instead joining the underground. In this kind of world, the official economy declines, often leading to
budget deficits and climbing tax rates.
• Official statistics — like GDP —
may be rendered less useful if they
don’t really capture the breadth of economic activity.
• It could be used as an unfair competitive advantage. Employers who
hire undocumented immigrants under
the table, for example, enjoy cost
advantages over firms that properly
report their employees and pay taxes
on them.
In a 2004 paper, the McKinsey
Global Institute found that countries
with big informal economies suffer
productivity losses. That’s basically
because the smaller firms that participate in the shadow world never gain
the scale and complexity of their
official competitors, whose own
operations are hampered by the existence of their under-the-table rivals.
“The powerful incentives and
dynamics that tie companies to the
gray economy keep them subscale and
unproductive,” researcher Diana

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

Farrell wrote. “Second, the cost advantages of avoiding taxes and regulations
help informal companies take market
share from bigger, more productive
formal competitors.”
Farrell’s solution: Wake up, official
economy! She advocates strengthening enforcement, eliminating red tape,
and cutting taxes. “Persistent myths
keep developing countries from
addressing the informal sector,” she
writes. “Yet diminishing its size would,
in almost every case, remove barriers
to growth and development and generate sizable economic gains.”

But What about Here?
Not surprisingly, the Internal Revenue
Service has an interest in the underground economy. In recent papers,
Kim Bloomquist, senior economist
with the IRS, has aimed to shoot down
theories that this nation’s tax code is
to blame for a large portion of the
informal economy. Acknowledging
that tax evasion is on the rise,
Bloomquist asks the obvious question:
“If neither increasing complexity nor a
rising tax and regulatory burden can
adequately explain the growth in noncompliant behavior, what else could
account for this phenomenon?”
His short answer: There’s been a
general shift away from more visible to
less visible sources of income. Where
this plays out most frequently is in the
wealthiest and poorest U.S. households. The middle class — people with
9-to-5-sort-of jobs — is extraordinarily
well-documented, with few easy
opportunities to avoid paying taxes.

By contrast, high-income households
collect a larger percentage of their
income in the form of “nonmatchable”
income, which is money not subject to
third-party information reporting and
withholding (like typical wages, dividends and social security benefits).
Taxpayers in the top 5 percent of the
income distribution account for more
than 77 percent of this nearly “invisible” income, Bloomquist says.
On the other end of the scale, the
poorest Americans are more likely to
deal in cash and thus less likely to be
subject to third-party reporting.
These trends worry economists like
Bloomquist, especially as income
inequality widens in the United States.
“Further polarization of the nation’s
income distribution could act to undermine current and future tax-enforcement efforts,” he wrote in a 2003 paper.
Meanwhile, the informal economy
cruises along. Nobody is terribly exercised about scrip currency in Floyd.
Neither myself nor the guy who shoveled my walk fear reprisal from authorities. And we are arguably better for it:
There was an immediate demand for a
shoveled walk and he offered the supply.
Talk about efficient.
Feige, the University of Wisconsin
economist, strives for clarity. He
scorns studies that lump the unreported, unrecorded, and illegal economies
together without explaining their distinctions. He believes much of the
research on informal economies suffers because of authors’ failures to
stick to uniform definitions of what
constitutes “underground.”

And though he considers the problem of unreported, unrecorded, and
informal economic transactions to be
worse in developing countries, he is
not so fast to write off the United
States’ experience as inconsequential.
“Shifting the burden to honest taxpayers has significant implications,” he
says. Schneider, the Austrian economist, is of two minds about the U.S.
underground: “A very difficult question,” he says. “I think a shadow economy of 10 percent, which leads to
additional value added has an overall
positive effect on the welfare of the
United States.” But a case can be made
that tax losses from even a 10 percent
shadow economy are too great for the
state to ignore, he adds.
In his 2003 book, Reefer Madness:
Sex, Drugs and Cheap Labor in the
American Black Market, investigative
writer Eric Schlosser invokes Adam
Smith’s “invisible hand” theory that
men pursuing their own self-interest
will generate benefits for society as
a whole. This invisible hand has
produced a fairly sizable underground
economy, and we cannot understand
our entire economic system without
understanding how the hidden underbelly functions, too. “The underground is a good measure of the
progress and the health of nations,”
Schlosser writes. “When much is
wrong, much needs to be hidden.”
Schlosser’s implication was that much
is wrong in the United States. If he
had taken a more global view, he
might have decided relatively little is
hidden here.
RF

READINGS
Bloomquist, Kim. “Tax Evasion, Income Inequality and Opportunity
Costs of Compliance.” Paper presented at 96th Annual Conference
of the National Tax Association, Chicago, November 2003.

Ratner, Shanna. “The Informal Economy in Rural Community
Economic Development.” TVA Rural Studies Contractor
Paper 00-03, February 2000.

de Soto, Hernando. The Other Path: The Invisible Revolution in the
Third World. New York: Harper & Row, 1989.

Schlosser, Eric. Reefer Madness: Sex, Drugs and Cheap Labor in the
American Black Market. Boston: Houghton Mifflin Co., 2003.

Dixon, Huw. “Controversy: On the Use of the ‘Hidden Economy’
Estimates.” Economic Journal, June 1999, vol. 109, issue 456,
pp. 335-380.

Schneider, Friedrich. “The Size of the Shadow Economies in 145
Countries All over the World: First Results over the Period 1999
to 2003.” IZA Discussion Paper no. 1431, December 2004.

Feige, Edgar. “Overseas Holdings of U.S. Currency and the
Underground Economy.” Economics Working Paper Archive at
Washington University, St. Louis, January 2005.

Visit www.richmondfed.org for links to relevant sites and
supplemental information.

Spring 2005 • Region Focus

19

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

Some prices are slow to change.
Are they sticky enough to affect monetary policy?

ven if you’re not familiar
with the term “sticky
prices,” you encounter
them all the time. How many years
has your newspaper sold for 50 cents
a copy? No matter if interest rates
are moving up or down, the price of
your newspaper hardly ever changes
— it’s sticky.
Economists take for granted that
some prices are rigid, slow to shift
even as supply and demand conditions might seem to warrant. For
many economists, these “nominal
frictions” are enormously important,
a core reason why monetary policy
matters.
For other economists, however,
sticky prices are neither widespread
nor meaningful in the slightest for
public policy.
Differences of opinion are humdrum stuff in economic circles. But
on the issue of sticky prices, the level
of disagreement is sharp and raises
some exceptionally high stakes.
Economists build mathematical
models that are supposed to help
policymakers decide when and how
much to change interest rates. In
recent years, sticky-price models have
gained currency and are being used
to inform Fed decisionmakers in
setting interest rates.
But if sticky prices don’t really
matter for monetary policy, as some
prominent economists theorize, then
what use are sticky-price models to
the Federal Reserve System?
More to the point: If sticky prices
don’t matter, does the Fed?

E

20

Region Focus • Spring 2005

The behind-the-scenes debate
about the importance of sticky prices
is going on at the uppermost levels of
economic thinking. Ben Bernanke, a
Fed governor on leave from Princeton
University’s economics department,
referred optimistically to the evolution of sticky-price models in a 2004
speech: “The insights from these
types of modeling efforts are already
informing policy analysis at the
Board, and their influence will only
grow as they become more detailed
and realistic.”
But where Bernanke sees promise
in sticky-price models, others see
inescapable flaws. Patrick Kehoe,
monetary adviser at the Minneapolis
Fed — whose president, Gary Stern,
is a voting member in 2005 on the
Federal Open Market Committee —
suggests that economists ditch further research on sticky-price models.
“No one has really yet made a convincing quantitative case for them,”
he says.
It is difficult to predict when, if
ever, a resolution will happen. But
how the sticky-price debate is settled
may have significant implications for
public policy.

A Sticky-Price Illustration
At the supermarket, the price of a box
of brand-name cornflakes seldom
fluctuates. For months it may be
$2.49, perhaps going on sale for $1.99.
As long as it stays at within those
two bounds, the price of cornflakes is
considered sticky.
Intuitively, you might expect more
frequent price changes for a box of

cornflakes. Say it was a bumper crop
year for corn — shouldn’t the price
of cornflakes then fall because of the
increased supply? But for microeconomic reasons they don’t budge. Firms
must weigh factors like “menu costs”
— literally, the cost of setting new
prices as on a restaurant menu — and
the psychological impact on customers
who are accustomed to the old price.
Simply put, prices tend to change only
when it’s financially advantageous for
the producer to do so. Similar reasoning can be applied to changes in workers’ wages.
The fact that prices don’t continuously move is believed by many
economists to be the key insight into
how monetary policy can affect the
economy. It is an underlying justification for so-called “monetary nonneutrality” — that is, why money
matters. This is in contrast to “monetary
neutrality,” which posits that an increase
in the money supply would simply be
offset by rises in prices and wages.
When the Fed sets policy for the
federal funds rate, it is influencing
the growth of the money supply. If
prices weren’t sticky, and in the
absence of other frictions, then theoretically the Fed’s actions wouldn’t
matter for economic output. Put
another way, if there’s more money
available with no change in prices,
then consumers theoretically will buy
more cornflakes. Cornflakes seem
cheaper in this scenario. Conversely,
if there’s less money in circulation,
shoppers will dial down their cornflake purchases since their price now
seems high. Because prices don’t

ILLUSTRATIONS: AILSA LONG

BY DOUG CAMPBELL

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

immediately adjust, the Fed’s behavior has the potential to affect the real
economy.
The degree to which some economists believe prices are sticky tends
to shape their beliefs on monetary
policy. Sticky-price fans tend to be
more optimistic about the potential
importance of monetary policy, while
sticky-price disbelievers often view
monetary policy choices as relatively
unimportant. At the same time, both
sides are inclined to agree that price
stability is the most desirable outcome of monetary policy — and generally don’t subscribe to the old
Keynesian notion that the central
bank should use monetary policy to
try to fine-tune the economy. It’s
just that sticky-price believers view
monetary policy as effective because
of the existence of sticky prices; the
skeptics see monetary policy’s powers
as more wrapped up in how successful
the central bank is at communicating
its intentions and not surprising the
market with wild fluctuations in
interest rates.
Today, macroeconomists rely on
intricate economic models to examine
the impact of the money supply on
the real economy. Those models in
turn inform policy deliberations of
the Federal Open Market Committee.
There now exist two main schools of
thought: one that thinks sticky prices
matter and any modeling that doesn’t
use them will produce misleading
results; the other that sticky prices
don’t matter and that standard realbusiness-cycle models work just fine,
thank you very much.
These camps are neatly encapsulated in the views of two leading economists: Jordi Galí and the aforementioned Patrick Kehoe. In between is
Alex Wolman, an economist with the
Federal Reserve Bank of Richmond
whose sticky-price research is widely
cited.

The Believer
Galí is a professor at the Universitat
Pompeu Fabra in Barcelona, Spain,
who has concentrated on monetary
policy and the business cycle. He is a

passionate believer that sticky prices
play an important role in explaining
how monetary policy works.
“Not only do they matter but they
are probably the single most important reason why monetary policy
plays such a central role in modern
economics,” Galí says. “In the absence
of nominal frictions, monetary policy
would be largely irrelevant and inflation and its costs a secondary concern
at most.” With that theoretical underpinning, Galí is forging ahead with
research on the interaction between
sticky prices and monetary policy
rules.
Much of his work seems to
debunk long-held views about how
the business cycle works. For example,
Galí and two co-authors argued in
a recent paper that it’s because of
sticky prices that increased government spending may actually raise
consumption among forward-thinking
consumers.
This is in contrast with the
prediction of standard “neoclassical”
economic models, which suggest that
such expenditures may not have this
effect because individuals are foresighted and recognize that a government that increases spending today
will likely have to decrease spending
or raise taxes in the future; as a result,
those consumers do not necessarily
alter their consumption patterns.
While Galí and his neoclassical
colleagues may disagree over the
empirical effects of increased government spending, both sides caution
that economic analysis alone cannot
determine whether such spending is
desirable.

The Skeptic
Over at the Minneapolis Fed, Patrick
Kehoe is doubtful. In reviewing the
past two decades’ work on sticky-price
models, Kehoe sees rampant shortcomings. No work, he says, has succeeded in
replicating output blips like those seen
during the Great Depression. “Most
people who play the sticky price game
don’t try to account for episodes in the
data,” Kehoe says. “The way the monetary literature has gone recently, they

Product/Services
Newspapers
Haircuts for men
Beauty parlor services
Film processing
Cemetery lots
Paint
Computer software
Prescription drugs
Pet food
Beer
Cigarettes
Jewelry
Cereal
Women's footwear
Lunch meats
Ice cream
Frozen orange juice
Roasted coffee
Bananas
Women's dresses
Eggs
Airline fares
Tomatoes
Unleaded gasoline

Average No. of Months
Between Price Changes
29.9
25.5
22.9
18.2
13.5
7.0
5.5
5.4
5.2
4.3
4.1
3.7
3.4
3.0
3.0
2.7
2.4
2.2
1.8
1.5
1.0
0.9
0.8
0.6

SOURCE: Data selected from Bils and Klenow (2004)

seldom ask serious questions like that.”
As ammunition, Kehoe points to
some recent research on just how
un-sticky prices in the U.S. market really
are. In 2002, Mark Bils of the University of Rochester and Peter Klenow
of Stanford University first reported
findings from their look into a new
trove of data: previously unpublished
information on individual consumer
prices collected by the Bureau of
Labor Statistics. In aggregate, those
data make up the consumer price
index, compiled by government
employees who literally observe prices
of hundreds of individual products,
from groceries to magazines, store by
store. Bils and Klenow got special permission to review the micro-data on
prices and concluded that these prices
actually change quite frequently, on
average about every four months. That
doesn’t seem so sticky, Kehoe argues.
Additionally, Kehoe cites new research
suggesting that when prices change,
they do so in big chunks, much bigger
than relative to what you’d expect
based just on money shocks.
Thus to Kehoe, much of the work

Spring 2005 • Region Focus

21

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

on sticky-price models is pointless.
Unable to produce results that match
actual economic data, sticky-price
enthusiasts are reduced to weakly arguing that their models can account for
what happens after a monetary shock
while admitting that monetary policy,
broadly defined, accounts for only a
tiny fraction of the business cycle,
Kehoe says. “If that’s true, then why are
we looking at it in the first place?” he
asks with exasperation in his voice.
Galí counters the criticism that
sticky-price models don’t explain
periods like the Great Depression by
referring to new variations of stickyprice models that have been enriched
with features like habit formation
and capital adjustment costs. In these
models, “It is much easier to generate
persistent output fluctuations, even
in response to monetary policy
shocks,” he says. Equally, Galí argues
that just because he believes in the
power of sticky prices doesn’t mean
he thinks they’re the only important
factor in the economy. “The fact that
nominal rigidities play an important
role in the economy does not necessarily imply that monetary policy
shocks should be an important source
of fluctuations; there are other
shocks in the economy.”

The Moderate
On the matter of sticky prices, the
Richmond Fed’s Alex Wolman is something of an agnostic. Wolman got in on
the ground floor of modern stickyprice modeling through his serendipitous association with Robert King,
then a professor at the University of
Virginia, where Wolman was a Ph.D.
student. King — now at Boston
University and a consultant to the
Richmond Fed — was at the forefront
of incorporating sticky prices into
equilibrium business cycle models.
Since the 1990s, Wolman has
worked with both so-called “statedependent” and “time-dependent”
sticky-price models. In state-dependent models, firms essentially are presented with an economic choice
about whether it’s a good time or bad
time to switch prices, and the sole
22

Region Focus • Spring 2005

criterion for making that decision is
whether it will cost more to the firm
to keep prices stable than to incur a
menu-type cost to change them. By
contrast, in “time-dependent” models,
prices are automatically changed or
not after a certain period.

“We as economists
don’t know exactly
how what the Fed
does matters for the
real economy.”
Wolman argues that state-dependent models are superior to timedependent versions because they more
accurately mirror the real economy.
They don’t impose so much structure
on firms as they allow them to decide
when to adjust prices based on environmental conditions — whether it’s
cheaper to leave prices unchanged or
not. But the trade-off is that statedependent models are more technically involved, so on occasion Wolman
prefers to work with time-dependent
models. Among other things, Wolman
has used time-dependent sticky-price
models to argue that the Fed isn’t powerless when nominal interest rates
reach zero.
Wolman continues his research
with sticky-price models. He is trying
to both understand them better —
especially their implications for monetary policy — and to advance them.
As widely used as sticky-price models
are today, they still aren’t all that well
understood, he says.
Long-term, where Wolman sees
the most promise is where Kehoe
sees the most problems. The same
Bils and Klenow data that showed
shorter periods of time between
price changes
also show

enormous variance, or “heterogeneity.” Wolman thinks sticky-price
models can begin to incorporate the
vast differences in how firms change
prices — something that nobody has
really accomplished yet. “It’s not
straightforward to write down and
solve models with those features,”
he says. “What we need to understand is how that heterogeneity in
the frequency of price adjustment
matters.” The upshot, Wolman
hopes, will be a model that produces
results more consistent with actual
economic data.
Building such a model is important because it will help us get at the
central issue of this debate: the
extent to which monetary policy and
the Fed matter in the real world.
The irony that a monetary skeptic
is serving as monetary adviser at a
Federal Reserve bank is not lost on
Kehoe. But he doesn’t necessarily see
it as a conflict. To be sure, there is
evidence that monetary policy run
amok can severely damage an economy — witness runaway U.S. inflation
in the late 1970s, a phenomenon
many economists including Kehoe
attribute to the Fed’s poor handling
of the money supply.
At the same time, Kehoe thinks
the reverence with which the U.S.
Federal Reserve System is held by
some may be overstated. The Fed
cannot hope to smooth every blip in
the economy with monetary policy,
he says, because it doesn’t really
wield that kind of power. The perceived failure of sticky-price models is
case in point for Kehoe. “I could well
imagine that monetary policy is
important in a variety of ways, but I
don’t think that the profession in
general and sticky-price enthusiasts in particular have a handle on
the mechanism by which it is,” he
says. “I’m perfectly comfortable
working at the Fed without thinking
that the Fed can save the day for every
recession and at the same time think
it’s important to keep prices stable.”
Perhaps surprisingly, sticky-price
enthusiast Galí somewhat shares
that sentiment: “The presence of

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

high and persistent levels of unemployment in many industrial
economies can hardly be attributed
to nominal rigidities. At most,
monetary policy can provide a
temporary patch.”
In other words: Monetary policy
is not the cure-all salve for the economy that the popular media have
lately told you about. Both Kehoe
and Galí agree that it’s good for some
things, but not all things — though
Galí is more enthusiastic about it
than Kehoe.
Their differences are nuanced but
important. With regard to monetary
policy, Kehoe is content to shoot for
general price stability and then let the
real economy work out other kinks
on its own. Gali, by contrast, draws a
strong connection between the existence of sticky prices and the effectiveness of monetary policy. Because
of this, he has greater confidence
in monetary policy’s ability to guide
the behavior of the real economy.
Wolman isn’t at all ready to give
up on sticky-price modeling, but he
think a lot more work remains:
“I believe what the Fed does matters.
But we as economists don’t know
exactly how what the Fed does
matters for the real economy.”
He pauses. “It’s slow going for
people to reach a definitive conclusion about the effects of Fed behavior on the real economy. Hopefully,
by gathering more data and building
more models, we can become better
informed about this question.” RF

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Our New
and Improved
Web Site
www.richmondfed.org

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READINGS
Bernanke, Ben S. “Monetary Policy Modeling: Where Are We and
Where Should We Be Going?” Remarks at the Federal Reserve
Board Models and Monetary Policy Conference, Washington, D.C.,
March 27, 2004.

Dotsey, Michael, Robert G. King, and Alexander L. Wolman.
“State Dependent Pricing and the General Equilibrium Dynamics
of Money and Output.” Quarterly Journal of Economics, May 1999,
vol. 114, no. 2, pp. 655-690.

Bils, Mark, and Peter J. Klenow. “Some Evidence on the Importance
of Sticky Prices.” Journal of Political Economy, October 2004, vol. 112,
no. 5, pp. 947-985.

Kydland, Finn E., and Edward C. Prescott. “Rules Rather Discretion:
The Inconsistency of Optimal Plans.” Journal of Political Economy,
June 1977, vol. 85, no. 3, pp. 473-492.

Chari, V. V., Patrick J. Kehoe, and Ellen R. McGrattan.
“Sticky Price Models of the Business Cycle: Can the Multiplier
Solve the Persistence Problem?” Econometrica, September 2000,
vol. 68, no. 5, pp. 1151-1179.

Wolman, Alexander L. “Real Implications of the Zero Bound on
Nominal Interest Rates.” Federal Reserve Bank of Richmond
Working Paper no. 03-15, December 2003.
Visit www.richmondfed.org for links to relevant sites.

Galí, Jordi. “New Perspectives on Monetary Policy, Inflation, and the
Business Cycle.” National Bureau of Economic Research Working
Paper no. 8767, February 2002.

Spring 2005 • Region Focus

23

The falling dollar has made

hina is famous for its exports,
but this nation of 1.3 billion
people is also one of the
American goods more attractive
world’s biggest importers. Thanks to
falling dollar, it may become even
to consumers abroad, but not the
more so. In 2004, China bought
machinery from firms in Maryland
everyone is happy about the and Virginia. China also bought wood
from North Carolina — lots of it.
currency’s slide China bought organic chemicals
from South Carolina and plastic from
West Virginia. And China isn’t the
B Y B E T T Y J OYC E N A S H
only country buying U.S. goods — the
A N D J E N N I F E R WA N G
dollar is making U.S. prices look good
these days.
After cresting in 2002, the dollar
has retreated to exchange rates not
seen since the mid-1990s. Overall,
the weakened dollar helped lift Fifth
District exports during 2004 by 13.5
percent, with $53.2 billion worth of
goods
being
sent
overseas.
Manufacturers of chemicals, machinery, plastic, and vehicles have seen
the biggest gains. Wood exports also
grew, while apparel and woven fabric
exports dropped off.
But does the falling dollar portend
trouble if the
United
States
Going Abroad
must
keep
borState Merchandise Export Totals
rowing from forState
Exports 2003
Exports 2004
% change
eign investors to
District of Columbia
809,220
1,164,327
44
finance its conMaryland
4,940,631
5,746,142
16
sumer and govNorth Carolina
16,198,733
18,114,767
12
ernment spendSouth Carolina
11,772,894
13,375,890
14
ing? Or will the
Virginia
10,852,981
11,630,744
7
depreciation
West Virginia
2,379,808
3,261,683
37
enhance U.S. comFifth District
46,954,267
53,293,553
14
petitiveness and
United States
723,743,177
817,935,849
13
help keep economic
growth
NOTE: Figures are in thousands of dollars
SOURCE: Department of Commerce
strong?

C

Falling Dollar, Rising Exports
Economists are debating the longterm implications, but the falling dollar’s impact in 2004 was favorable for
many U.S. firms. North Carolina
24

Region Focus • Spring 2005

exported $18 billion worth of goods in
2004, 11.3 percent more than 2003.
“The weaker dollar’s having a huge
impact on our business worldwide,”
says Peter Cunningham, director of
the International Trade Division at the
North Carolina Department of
Commerce.
The Tar Heel state exported 50 percent more pharmaceutical products in
2004 than it did in 2003, but it also
exported almost 22 percent more cotton and yarn. And $5.4 million of the
cotton and yarn exported went to
China, an increase of 36 percent to
that country. Knit apparel, however,
dropped by nearly 19 percent, a trend
that many think will continue.
Likewise, South Carolina sent 63 percent more cotton and yarn abroad last
year, with China being its second best
customer.
Strong cotton and yarn sales fuel
overseas apparel shops, says Donald
Brasher, president of Global Trade
Information Services, based in
Columbia, S.C. North Carolina is the
No. 1 exporter of cotton yarn, and
with the removal of textile quotas,
China will produce even more apparel
for export. That may be bad news for
what’s left of the Fifth District apparel sector. But China is going to need
cotton — lots of it. “We might be
sending more yarn to China or we may
be just sending more raw cotton,”
Brasher notes.
Will China buy another traditional
Fifth District manufactured product
— furniture? Perhaps. In 2004, North
Carolina exported about 23 percent
more furniture and bedding to China
than the previous year.
North Carolina exported about
$253 million in furniture and bedding
in 2004, about 3 percent more than
2003, according to Global Trade
Information Services. Most furniture
companies have not embraced the

ILLUSTRATION: GETTYIMAGES AND LARRY CAIN

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

The Dollar’s Slide Against the Euro
the lack of domestic savings,
one piece of the dollar puzzle. If
foreign investment falls, the
United States could be stuck
paying higher interest rates.
Federal Reserve Board
Governor Edward Gramlich
recently focused on savings in a
speech, concluding: “In the
short run, output growth is
healthy and inflation rates are
stable. Investment shares are
reasonable, but that is largely
because the United States is borrowing such a huge amount from world
capital markets. The key question is
whether this borrowing is sustainable.
However sustainable it is, the United
States would seem well-advised to
minimize risks by raising its own
national saving to finance its own
investment. That would stabilize
investment in the short run and
increase profitability in the long run.”
Walden notes that personal savings
calculations don’t capture capital
appreciation in such things as homes
or 401(k) plans. Also, one “could argue
that education and research are investments,” and compared to other countries, the United States spends a high
share of its national product on those
things.
While the falling dollar has benefited American exporters, the effect on
some domestic manufacturers and
consumers has been quite different.
“Relative prices of all internationally traded goods increase with dollar
depreciation. U.S. producers of these
goods gain, but all U.S. buyers are
harmed,” says Thomas Grennes, a colleague of Walden’s at N.C. State. “For
example, U.S. producers of steel gain
from more expensive imported steel,
but U.S. makers of automobiles and all
users of steel are harmed because their
costs increase.”
RF

Feb 05

Aug 04

Nov 04

May 04

Feb 04

Aug 03

Nov 03

Feb 03

May 03

Aug 02

Nov 02

Feb 02

May 02

Euro/U.S. Dollar Exchange Rate

export strategy but are being
1.3
urged to expand to international
1.2
markets because of the falling
1.1
dollar. North Carolina’s biggest
1.0
furniture customers in 2004
0.9
were Canada and Australia.
0.8
“I use this example: A $500
0.7
sofa two years ago would have
0.6
cost 560 euros, today it’s about
400 euros,” says Jeremy Ruff of
the North Carolina Department
SOURCE: Bloomberg
of Commerce’s Furniture Trade
Office. “Just the difference in
the exchange rate is pretty dramatic.”
late 2004. Waldman notes that the
For exporters, the effect of the
growth in demand for U.S. exports has
declining dollar is easy to understand:
moderated as economic activity in cerA depreciated dollar makes U.S. goods
tain key countries has weakened, namely
more affordable. And more foreign
Germany and Japan.
tourists travel in the United States
“In terms of what we really need to
because their money goes further. One
see the dollar do, it has not gone back to
dollar was worth .76 euros in March, so
the levels where we needed it to be
a $5 lunch cost 3.81 euros for German
competitive,” Waldman says. He points
tourists in Washington, D.C.
out that in the early 1990s, the dollar
Linda Yelton, manager of internaappreciated more than 70 percent from
tional research at the Travel Industry
1992 to February of 2002, and almost
Association of America, notes that
40 percent of that occurred from 1995
travel to the United States from
to 2002. Since then, the dollar has
Europe, the United Kingdom, and
declined roughly 40 percent against the
Asia increased last year. In total, overeuro, but considerably less against a
seas travel to the United States rose by
larger basket of currencies.
14 percent over 2003.
Likewise, Michael Walden, an econFifth District companies are beneomist at North Carolina State
fiting from increased international
University, sees no threat in the declintourism indirectly as well as directly. In
ing dollar. He believes the dollar was
February, Goodrich Corp. of
overvalued prior to its recent decline.
Charlotte, N.C., announced a contract
“We’re at a level commensurate with
worth $6 billion over 20 years with airwhere we were in the mid-1990s.
plane maker Airbus of France.
It’s going to have a positive impact on
our economy,” he says. “It’s an automatic stabilizer, if one is worried about
How Low Can You Go?
the trade deficit. It stimulates exports
The dollar may be falling but it
and makes imports more expensive,
hasn’t tumbled enough to suit Cliff
eventually.”
Waldman, an international economist
for the trade group Manufacturers
Alliance. He thinks the dollar needs to
America’s Savings Rate
keep dropping to close the ever-widenThe capital flowing into the nation
ing trade deficit, which reached almost
from abroad has financed consumer
6 percent of gross domestic product in
and government spending, reflecting
READINGS
Bivens, Josh. “The Benefits of the Dollar’s Decline.” Economic
Policy Institute Briefing Paper no. 140, July 24, 2003.
Gramlich, Edward. “The Importance of Raising National Savings.”
Remarks Delivered at Dickinson College, March 2, 2005.

Obstfeld, Maurice, and Kenneth Rogoff. “The Unsustainable U.S.
Current Account Position Revisited.” National Bureau of
Economic Research Working Paper no. 10869, October 2004.
“The Disappearing Dollar.” The Economist, December 4, 2004, p. 9
Visit www.richmondfed.org for links to relevant sites.

Spring 2005 • Region Focus

25

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THE

IDENTITY BUSINESS
Biometrics Cluster Sharpens
West Virginia’s Economic Image
B Y B E T T Y J OYC E N A S H

TMC Technologies’ Alan Viars assesses
digital fingerprint collection systems at the
Biometrics Fusion Center in Clarksburg, W.Va.

26

Region Focus • Spring 2005

ucked among the ridges and valleys of West Virginia, on land
once stripped for mineral
wealth, sits the biggest stash of fingerprint data in the world. The Federal
Bureau of Investigation’s Criminal
Justice Information Services Division
(CJIS) is 10 years old, employs more
than 2,300 people, and forms the root
of a new economic identity for West
Virginia — biometrics.
The CJIS center has spawned a biometrics cluster. From certification labs
to technology parks to technology
transfer groups, the industry is taking
hold, according to Tom Witt, director
of the West Virginia University Bureau
of Business and Economics. “The indication we have nationally is that this is
a center for biometrics. We’re on the
map, the radar screen.”
Biometrics uses physical traits to
determine and verify identity, and as a
result, speed transaction time. A quick
fingerprint scan identifies you at a
supermarket counter so there’s no fumbling for credit cards. Or perhaps you
enter the workplace by staring into a
machine that scans the unique pattern
of your retina.
The payoff could be big as the biometrics business grows along with
national anxiety over security and identity fraud. An industry association, the
International Biometric Group (IBG),
predicts revenues will quadruple in the
next four years, from $1.2 billion in
2004 to $4.6 billion in 2008.
Corporations such as defense giant
Lockheed Martin maintain a mountain
presence with about 250 employees in
the region anchored by the FBI. West
Virginia has built on this biometrics
base with the goal of transforming the
manufacturing and mining mentality
into a technology focus. To capitalize on
the CJIS center, the state is

T

pumping money into university research
funds and the state’s venture capital
fund. West Virginia is also cultivating
its most valued resource — people.
Alan Viars is the kind of knowledge
worker West Virginia covets. He is a
1999 graduate of West Virginia
University, with master’s degrees in
computer science and business administration. Viars works in Clarksburg as a
contractor at the U.S. Department of
Defense’s Biometrics Fusion Center,
the hub of defense biometrics research,
testing, and evaluation. The center,
located on Main Street among vacant
storefronts and next door to the
Ordinary Restaurant and Pub, is only
three and a half hours from Viars’
hometown of Comfort, near the Coal
River in Boone County. But technologically, it’s light years away.
“I was offered a job and it happened
to be involved with biometrics, so I
picked it up after college,” he explains of
his career path. Viars, who hails from a
family of entrepreneurs, works on
developing data-sharing software,
among other tasks. “I do a lot of pilots
to make sure things go well.” He sees the
industry, in particular the fusion center,
as a permanent outcropping among the
West Virginia hills. “I can tell you that I
don’t think this place will ever go away.”
In fact, a new home for the fusion center is planned on the FBI grounds with a
projected 2006 construction start date.
Currently, the fusion center employs
about 100 people, many of them contractors. There are 150 to 175 jobs slated
for the new location.
Viars heads Viametrica, a fledgling
spin-off from West Virginia-bred TMC
Technologies, started by native Wade
Linger. Lockheed Martin, with help in
biometric expertise from TMC,
recently won a five-year, $25 million
contract to work on the Automated

Biometric Identification System
(ABIS) to store and search fingerprints
collected worldwide by the Defense
Department. The system will be able to
search the database of arrestees maintained by CJIS, a big step forward.
CJIS, the fusion center, private technology firms, and a variety of state and
federal institutions comprise a technology trail in the north central part of the
state that runs along Interstate 79 from
Clarksburg to Morgantown, home of
West Virginia University (WVU). It also
stretches west along Interstate 64 to
include Marshall University and its
forensics center.
Biometrics has become almost a
household word around this region.
Employees at the Biometrics Fusion
Center, for example, spend 10 percent of
their time fanning out into the community to offer programs. High schools
encourage students to explore biometrics, and the fusion center offers internships for college students. The CJIS
facility likewise reaches out. There are
school children in West Virginia who
have their fingers scanned to deduct
lunch money from accounts, while some
students at WVU gain access to dorms
via hand readers.

Reclaim Land,
Claim Opportunity
Once the CJIS facility cranked up,
West Virginia closed in on its plan for a
biometrics cluster. West Virginia’s
economy historically depended on natural resource extraction and heavy
manufacturing, both now declining.
That left West Virginia’s per-capita
income at 78 percent of the national
average in 2003, 49th among the states,
and its young people bound for opportunities elsewhere.
Efforts by U.S. Sen. Robert Byrd,
D-W.Va., brought the FBI division to
986 acres of reclaimed strip mines near
Clarksburg. It opened in 1995 and its
effects were immediate. Between 1992
and 1998, the average annual employment growth rate in the three-county
area that includes Clarksburg rose by
3.16 percent compared to the statewide change of 1.7 percent.
Today, CJIS employs about 2,350

people in jobs ranging from statisticians to mechanical engineers to fingerprint readers, among others. Lisa Stout,
an arts and information specialist
there, has worked for the division since
1999. She grew up here and is grateful
for employment options that allow her
to stay close to family as she raises four
children.
In 1999, CJIS launched its automated fingerprint identification system.
Response time for identifying criminal
submissions dropped from weeks to
less than two hours. CJIS stores 48 million sets of arrestee fingerprints, the
oldest and most widely used biometric.
This database is critical in identifying
terrorist suspects; it is linked to
the U.S. Department of Defense’s
Automated Biometric Identification
System to check fingerprints of
detainees, prisoners, or suspected
terrorists.
The area’s institutions have attracted contractors from international firms
and mountain startups, many working
on federally funded projects. For example, Computer Sciences Corp. (CSC) of
El Segundo, Calif., obtained a four-year,
$52 million contract to support the
Biometrics
Fusion
Center
in
Clarksburg. CSC will do it with the
help of home-grown businesses such as
TMC as well as WVU and the West
Virginia High Tech Foundation.
“Obviously in light of what happened Sept. 11, many people across the
world all of a sudden discovered biometrics,” notes Jamie Gaucher of the
West Virginia Development Office.
“We were ahead of the curve. That gave
us a boost and gained the state a great
deal of recognition.”
Michael Yura, senior vice president
of the nonprofit National Biometric
Security Project (NBSP), says WVU’s
biometrics and forensic identification
majors were “simmering on the back
burner until 9/11, and then moved onto
the front burner on high.” The NBSP’s
center in Morgantown develops standards, tests, and evaluates biometric
technologies. WVU began its forensic
identification and biometrics majors in
1997, and serves about 1,000 students
today. The FBI approached Yura about

creating the majors because it needed
trained employees.
“When I see an increase in enrollment at the state’s largest educational
institution within this field, I think of
that as a resource,” Gaucher says, adding
that if a firm wants to find people with a
set of skills within the biometrics industry, West Virginia can supply them.
Tom Witt, the director of the
Bureau of Business and Economic
Research at WVU, says the growth in
federal agencies and associated contractors working with identification
technologies is dramatic.
“We came up with lists in the
Clarksburg-Morgantown area — CSC,
Galaxy Global, Azimuth, Lockheed —
as examples of firms we know have at
least a portion of their work in biometrics. Match that with efforts at the university and other initiatives within the
institution and you really see that it’s a
critical mass.” Witt says that it’s tricky
to calculate numbers of biometrics
employees because of the overlapping
skills and duties in this rather hybrid
business that is part computer science,
part engineering, with some bio-sciences thrown in as well.
TMC founder Wade Linger
returned to his native state in 1992 to
open an office for his then-employer
ManTech International Corp., which
worked on U.S. Navy contracts. The
company wanted a piece of the action
bubbling up in the wake of plans to
locate the FBI’s CJIS division. In 1996,
Linger formed his own firm. TMC’s
first biometrics work related to locating missing children through facial
recognition. TMC, which expects 2005
revenues of between $10 million and
$12 million over 2004’s $9 million, has
endowed a biometrics scholarship at
WVU. Biometrics has migrated into
the mainstream, Linger says.
“It’s gone from a fringe thing, with
some real dedicated geeky types that
play in it and come up with stuff that
sometimes works and sometimes is
hype — it’s gone from that to something that’s a very serious core technology that’s going to be at the core of
some important systems, like financial
systems and criminal justice and a lot of

Spring 2005 • Region Focus

PHOTOGRAPHY: BIOMETRICS FUSION CENTER, CLARKSBURG, WEST VIRGINIA

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

27

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

stuff that the military is doing, such as
refugee identification,” he says.

The Human Equation
Identity can be verified through possession (a card, key, or token), knowledge,
(personal identification number or
password) or existence (physical traits
such as fingerprints, iris patterns, hand
geometry, or facial characteristics).
Biometrics ratchets the identity business up a couple of notches. It transforms physical characteristics into
codes that can be matched against a
database to verify identity. The idea
is to make sure you are who you say
you are.
Fingerprints, the oldest and most
common biometric, have been used in
identifying criminals for at least 100
years. In England in 1902, fingerprints
helped convict someone of murder for
the first time. In the 1920s, the U.S.
Federal Bureau of Investigation became
the repository for fingerprint data.
Multiple, complicated passwords —
a pet’s name or a great uncle’s cousin’s
brother with the strange first name —
are the norm these days in the workplace. But some firms are already getting more sophisticated with finger
scans or iris recognition. At the
Biometrics Fusion Center, for example,
a very perfect female voice directs
A soldier enrolls her iris with an iris reader
at the Biometrics Fusion Center.

28

Region Focus • Spring 2005

employees to “Please, move forward
a little” or “Please, move back a little”
so that the eye lines up with a wallmounted iris pattern reader. Iris pattern recognition devices comprised
about 9 percent of the market in 2004.
Science-fiction fans know voice
recognition from 2001: A Space Odyssey.
Today, voice recognition accounts for
some 6 percent of total biometrics sales,
according to IBG’s Biometrics Market
and Industry Report 2004-2008. Star
Trek II used scanners to allow Captain
Kirk access to the Genesis Project file.
All that — and more — is reality today.
Bank of America uses some palm scanners to admit customers to safety
deposit boxes.
Security measures mandated by
Congress have beefed up the government spending and propelled biometrics forward. For example, the U.S.
Visitor and Immigrant Status Indicator
Technology (US-VISIT) program starts
abroad, where consular offices issue
visas, collect biometrics (digital finger
scans and photographs), and check
them against a database of known
criminals and suspected terrorists.
When the visitor arrives at an entry
check in the United States, their biometrics — digital finger scans — match
the visitor to the same person who
received the visa.
By the end of 2005, US-VISIT will
operate at all ports. The U.S. government has set October 2005 as the deadline for requiring people from some 27
countries (Visa Waiver Program
nations) to develop machine readable
passports carrying biometric information on a chip.
The International Civil Aviation
Organization established facial mapping
as the global biometric standard for
the e-passports. And electronic U.S.
passports are in the testing phase.
A voluntary identification tool for
frequent travelers is under way at selected airports, using biometric identifiers.
Hand geometry readers already are
used at some workplaces not only to
verify identity but also to replace the
time clock. Face recognition, estimated
to be about 12 percent of sales, uses
video cameras to photograph and digi-

tally map points across a face to search
a database for a match to stored images.
Though the bugs in biometrics systems are still being worked out, along
with standards, the industry is coming
of age, especially as the U.S.
Department of Defense and Homeland
Security sink billions into security. The
director of the U.S. Department of
Defense’s Biometrics Management
Office, the policy arm of the fusion center located in Clarksburg, is John
Woodward. He studied biometrics for
almost a decade. The way to leverage
biometrics’ power as a tool for defense,
Woodward says, is to be able to search
the biometric information against as
many databases as possible.
“People say finding a terrorist is like
finding a needle in a haystack. You can
do exactly that. You can search to find
that needle in a haystack, but to do
that, searching data has to be in an
interoperable format,” Woodward says.
And that’s where the ABIS project
emerges. “We’re trying to take biometric data that the military collects from
enemy combatants, detainees, etc., and
collect that data, store it, and search it
to see if we can link to the person’s previous identities or past criminal
attacks,” he explains.

Cluster Effects
Woodward believes the fusion center’s
presence in West Virginia will be
healthy.
“The global war on terrorism is sadly
not going away anytime soon,” he says.
“I think you’ll see growth at our West
Virginia office.”
North central West Virginia’s geographic concentration of interconnected industries, many of which do
biometrics work, is based on the FBI
CJIS division and a wide array of government entities. Some of those include
the National Institute for Occupational
Health and Safety, the Center of
Biomedical Research Excellence, the
NASA Independent Verification and
Validation Facility, and the NASA West
Virginia Space Grant Consortium.
Economists who study clusters say
that even as the global economy and
technology have erased some of the

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

needs for companies in a similar business to work in proximity, there are
compelling reasons to do so.
Michael Porter of Harvard
University writes: “Even as old reasons
for clustering have diminished in
importance with globalization, new
influences of clusters on competition
have taken on growing importance in
an increasingly complex, knowledgebased, and dynamic economy.”
In short, clusters foster innovation.
And to promote the cluster, WVU has
beefed up its research funding from $60
million in 1998 to $140 million in 2004,
according to Russ Lorince, director of
economic development for WVU. The
goal is to reach $200 million by 2010.
And disclosures have ramped up as
researchers move closer to patents.
The economy in the region is diverse
— traditional mining and manufacturing jobs represent about 8 percent of
the work force and health care is the
major employer. The region’s work
force is educated — with 21 percent
having bachelor’s degrees compared to
14.8 percent statewide.
Jerry Paytas of Carnegie Mellon
University has studied clusters extensively. The advantage of an institutional
cluster, he notes, is stability. “The federal facilities aren’t going to suffer from
market shocks,” he says. “You can still
have shifts in political winds. In some
ways, those are more predictable. With
the federal government, you can negotiate a transition period.”
But an institutional cluster is often
focused on national needs and that can
limit the benefit to the region. “In
terms of making a decision, you might
try to get some business for local firms,
but they’re beholden to different criteria. They might have to get the lowest
supplier. Their mission is not to grow
your economy.”

Still, the industry is emerging and
observers say that’s why the best is yet
to come.

Biometrics Buzz
Industry experts say the biometrics
buzz will get louder, as worries about
access mount and as businesses get on
board and the technology gets cheaper and more accurate. Nearly all those
interviewed for this article said the
market, deployment of technology,
research, funding, and acceptance
had accelerated since 9/11. The
International Biometric Group estimates sales of fingerprint identification systems alone at $1.5 billion by
2008, largely because of projects such
as border control, immigration,
national identification cards, and
drivers’ licenses. And as public awareness expands, analysts expect commercial interests to blossom with particular emphasis on managing data in
financial services and health care.
Consumer convenience will determine acceptance. Some grocers,
including Piggly Wiggly Carolina Co.
with stores in South Carolina and
coastal Georgia, offer customers the
option of using a finger scan to access
a payment choice. Shoppers first register payment options along with the
fingerprint. Fifty percent of store
shoppers elected to use the scan. The
company’s senior vice president tested
the system last summer when he was
on a boat trip.
“I was wearing swim trunks and a
T-shirt. I went into the store emptyhanded. No wallet, no money,” David
Schools says. “I loaded a shopping cart
with drinks and chips and snacks, went
to the checkout, used my finger, paid
for my groceries, and was on my way.”
Biometrics technology is now living
up to the claims of the vendors, accord-

A technician at the Biometrics Fusion Center tests a
facial recognition system.

ing to IBG consultant David Ostlund.
He observes that post-9/11, people
have the notion in their head they need
to maintain security. One of the first
large-scale biometric deployments
began in the 1980s, with hand geometry devices at Ben Gurion Airport in
Tel Aviv, Israel. “They still use it.”
Off-the-shelf technologies are
available today, with fingerprint scan
devices on keyboards, Panasonic iris
recognizers, and a host of other technologies on the market. And that’s got
to be good news for the industry cluster in West Virginia.
The
industry’s
intellectual
resources are already on the ground in
West Virginia because of the federal
institutions, notes Jamie Gaucher,
with the West Virginia Development
office. “We’re on the verge of a smalland medium-sized business explosion
in biometrics.”
And that will help keep the young
people in the state. It may even draw
educated people from other states,
says Alan Viars. “I thought of leaving,”
Viars says. “But I found a job during
graduate school that involved biometrics. It was pretty easy for someone
with my background to fall into the
biometrics industry.”
RF

READINGS
Paytas, Jerry, Robert Gradeck, and Lena Andrews. “Universities and
the Development of Industry Clusters.” Carnegie Mellon University,
Center for Economic Development. Prepared for the Economic
Development Administration, U.S. Department of Commerce, 2004.
Porter, Michael. “Location, Competition, and Economic
Development: Local Clusters in a Global Economy.” Economic

Development Quarterly, February 2000, vol.14, no.1, pp. 15-34.
Woodward, John, Nicholas Orlans, and Peter Higgins. Biometrics.
New York: McGraw-Hill/Osborne, 2003.
Visit www.richmondfed.org for links to relevant sites and
supplemental information.

Spring 2005 • Region Focus

29

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

COMMUNITY
BANKING
A decade ago, small banks were being gobbled up by big banks, but those days
seem to be over. What are they doing now?
BY DOUG CAMPBELL

he way Roger Dick tells it, Bank
of Stanly opened its doors on
Jan. 26, 1984, in the tiny hamlet
of Albemarle, N.C., about 40 miles east
of Charlotte, on the strength of little
more than the community’s word that
it would support a small, locally owned
bank. In a town that had suddenly seen
two local banks gobbled up by larger
competitors, a handful of business leaders took the then-31-year-old Dick
aside and asked him if he’d be interested in helping them launch a new bank.
Dick was an executive of one of the
banks that was being acquired, and he
quickly agreed. He drew up an offering
circular himself, showed it to the North
Carolina Commissioner of Banks, and
got approval to start raising money. He
sold $2 million in stock from the trunk
of his car, insisting that no one hold
more than 1 percent of the outstanding
shares, a notion that many observers
would consider absurd today.
Surviving for any length of time as
a community bank in a rural market
is no easy feat. There have been plenty
of lean years, but the Bank of Stanly
today endures and has even added a
parent holding company to diversify its
interests.
To put this accomplishment in perspective, consider that a total of 10
banks, including Stanly, were chartered
in the Fifth District during 1984. Today,
only the Bank of Stanly remains. The
others were bought out or failed.
Says Dick, who serves as chief executive of the bank’s parent company:
“Occasionally, you get someone coming
through saying that, for some price,
you’re for sale. But if I sell the bank,

T

30

Region Focus • Spring 2005

then I sell control in the capital in our
community. I’m not going to sell.”

Why Community Banks Matter
Bank of Stanly’s status as sole Fifth
District survivor from the Class of ’84
speaks to a trend facing community
banks nationwide. At the end of 1984,
there were 14,351 banks with $1 billion
or less in assets across the country.
Entering 2004, that number was roughly halved to 7,337, according to figures
kept by the Federal Deposit Insurance
Corp. (Because these figures don’t control for inflation, a $1 billion bank in
1984 would, in real terms, be larger than
a $1 billion bank today.)
Records kept by the Fed tell a similar story in the Fifth District: Of the
310 banks that opened with new charters between 1984 and 2004, just over
half — 171 of them — continue today as
independent banks.
The pace of new bank charterings
has followed a parallel script. In 1984,
new bank openings approached 400
nationwide. Since then, there have
been ups and downs, but the general
trend is south.
Given those trends, it seems that
community banks are losing their economic place in the U.S. financial services
system, largely replaced by big banks,
credit unions, and stand-alone mortgage
brokers that are quickly filling the niches once occupied exclusively by homegrown banking institutions. And since
community banks now hold only a small
fraction of the country’s total financial
assets, they appear to create little systemic risk to the U.S. financial system.
All this raises the following question: Do

community banks matter anymore? Not
surprisingly, community bankers are
unequivocal about their utility, and point
to the importance of having close relationships with their customers, especially when it comes to making lending decisions. At the Bank of Stanly, Dick calls it
“financial services on a human scale.”
Thanks to a plugged-in board of
directors, community banks often are
privy to personal information about
clients that big banks either wouldn’t
know or wouldn’t factor in lending decisions. “We can get more information
without just relying on financial data
and still make a good decision about a
credit because we have a more holistic
insight into clients,” Dick says.
William Keeton, an economist at the
Federal Reserve Bank of Kansas City,
has studied the role of community
banks and concludes that they remain
viable and worthy of regulatory interest
— though certainly not on the scale
they did 20 years ago. In particular,
community banks are still significant in
many rural and some midsized urban
settings, as well as in the crucial realm of
small-business lending, Keeton says.
The sort of personal lending relationships described by Bank of Stanly’s
Dick are crucial to understanding why
community banks matter.
“It’s clear to me there’s going to be
demand on the lending side for the
kinds of services community banks
provide,” Keeton says. “Smaller banks
have an advantage collecting information. They know the market, they have
contacts in the community, and they’re
in a position to assess the borrower. I
don’t see that advantage going away.”

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

That “advantage” is the reason why
94 percent of this nation’s banks remain
“community” banks, defined as having
fewer than $1 billion in assets. On the
flip side, community banks, as you
might expect, are losing the battle for
market share. Nationwide, community
bank branches held 17.6 percent of all
deposits in 2002, according to a Fed
study, down from 29.2 percent in 1984.
And in the Fifth District, the 2002
figure was even lower at 16.4 percent.

Acquisition Targets
The ability of small banks to carve out
effective customer relationships has
long persuaded some displaced banking
executives to try their hands at opening
community banks. Even amid the general decline in numbers of community
banks, there have been several years
when new banks sprouted in large numbers, particularly when the economy
has been humming along. More than
200 banks were chartered nationwide
annually between 1987 and 1989; those
heights were reached again in the three
years between 1999 and 2000.
Arnold Danielson, chairman of
Rockville, Md.’s, Danielson Associates,
an investment bank, says the availability of capital is key in driving new bank
charters. Most new banks cater largely
to small business owners, Danielson
says. They thrive in markets that happen to be growing and are more at risk
in locations where the economy is stagnant. Investing in new banks in good
markets is almost always a wise move,
Danielson says.
Except for one thing: A major reason many new banks have proven to be
good investments is because they were
later bought for some multiple of their
book value. But the days of big banks
buying small banks have largely come
to an end. Big banks have used liberal
interstate branching laws to fill in their
turfs as much as they need.
So while nearly half the banks that

opened in the Fifth District since 1984
have already been acquired or failed,
the bulk of that activity happened
among banks opening in the 1980s and
early 1990s. Those banks that opened
in the late 1990s don’t seem to have the
same exit strategy for investors that
predecessors did.
“I made money on new banks, but
I’m not enthusiastic right now. I don’t
see an exit strategy,” Danielson says.
“So you just don’t have the typical
buyers any longer.”
Wood Britton, an investment
banker with The Orr Group in
Winston-Salem, N.C., remembers the
go-go merger years of the early- and
mid-1990s. In North Carolina, there
were five formidable “midsized” banks
— BB&T, Central Carolina Bank,
Centura, Southern National, and
United Carolina Bank — that frequently bid on the same deals for community
banks. But four of those five were
acquired by other banks, leaving only
BB&T, which has transformed itself
into a certified big bank with assets of
more than $100 billion.
“Nowadays, if I’m going to come
into North Carolina, buying a bank
with $500 million in assets is not
usually enough to make a dent in the
marketplace,” Britton says. So the
number of interested potential buyers
of banks of that size has diminished.
Community banks aiming to maintain their attractiveness to buyers
ought to locate only in strong growth
markets, Britton says. This is one
reason why so many more banks are
being bought in Florida in recent years
than in, say, the Carolinas.

Back to Basics: With a Few Twists
The last bank to open in the Fifth
District during 2004 was TriStone
Community Bank of Winston-Salem.
While already a crowded banking
environment, Winston-Salem is a
relatively strong market for growth in

North Carolina. And with the 1996opened Southern Community Bank
and Trust reaching almost $1 billion in
assets, TriStone organizers saw an opportunity: They would build a true “community” bank, now that Southern
Community was growing beyond the
benchmark $1 billion in assets.
Led by CEO Simpson O. Brown,
organizers raised $16.5 million and
opened TriStone on Nov. 30, one of 16
banks chartered in the Fifth District in
2004 — the highest annual total since
2000’s 18. At TriStone, they are not
reinventing the community banking
wheel. “We are a small business bank,”
Brown says. “A lot of folks talk about
customer service; we really put that
into practice.” Unusual amenities
include a fireplace and wide-screen TV
where clients are invited to linger.
On the more pressing matter of
competing with larger rivals, TriStone
has allied itself with a group of community banks through which it sells loans,
keeping its own risk level down while
making it seem to clients they can handle large deals.
“I think it’s a very viable strategy,”
Brown says. “We’ll do what’s in the best
interest of our shareholders, but we
didn’t build this model to sell.”
Not far down the road at Bank of
Stanly, CEO Dick wants the same thing
for his bank. But even after a 20-year
record of durability unmatched in the
Fifth District, he is more cautious. Like
TriStone, Bank of Stanly has diversified
its offerings and set up a parent company to branch out geographically.
Yet sitting in the heart of rural
North Carolina, where job losses in the
textile industry have been significant,
does not make Dick optimistic: “I
think the hardest period to deal with is
the one we’re in now. To achieve that
critical mass to be competitive is very
complicated. I wish it didn’t have to
be.” Even community banking is no
longer simple.
RF

READINGS
Critchfield, Tim, et al. “Community Banks: Their Recent Past,
Current Performance, and Future Prospects.” FDIC Banking
Review, 2004, vol. 16, nos. 3-4, pp. 1-56.

Keeton, William. “The Role of Community Banks in the U.S.
Economy.” Federal Reserve Bank of Kansas City Economic
Review, Second Quarter 2003, vol. 88, no. 2, pp. 15-43.
Visit www.richmondfed.org for links to relevant sites.
Spring 2005 • Region Focus

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ECONOMICHISTORY
Washstands, Sideboards, and Parlor Suites
BY RO B E RT L AC Y

Making Furniture
and Progress in
North Carolina’s
Piedmont

Early Hickory factory workers
take a break to pose in 1901.

urniture making has a long
tradition in the Piedmont region
of North Carolina. Many years
before High Point, Drexel, and
Thomasville became famous for furniture manufacturing, craftsmen in the
area provided the overwhelmingly rural
populace with handmade chairs, tables,
and beds.
In the 1800s, exceptional cabinetmakers in the Moravian settlement of
Salem (now Winston-Salem) and in
Quaker communities in Randolph and
Rowan counties worked wonders with
wood, creating furniture pieces that are
collectors’ items today. And Thomas
Day, a free African-American in antebellum Milton, N.C., had both the
artistic talent to design fine furniture
and the business acumen to run the
largest furniture-making operation in
North Carolina in the 1850s.
With such precedents, it’s not surprising that a modern, mechanized furniture manufacturing industry would
take root in North Carolina at the turn
of the 20th century. There were huge
timber operations in the state. Plenty of
oak, poplar, maple, and other trees suitable for furniture making remained to
be harvested. There were also plenty of
men available to work in furniture factories, an attractive alternative to the
drudgery of farm work during the era.

F

What was remarkable was just how
quickly the furniture-manufacturing
industry in Piedmont North Carolina
would grow in the early decades of the
20th century. By 1929, North Carolina
was among the top-five states in the
nation in the production of wooden
household furniture. Small towns in the
region were becoming as famous for furniture as the more industrialized cities
like Chicago, Cincinnati, and Grand
Rapids, Mich. A Southern furniture
industry had emerged in the Piedmont
region, with High Point as its center.
During its formative years, from
1880 to 1930, furniture manufacturing
played a key role in the industrialization of North Carolina. Along with the
textiles and tobacco industries, the furniture industry would demonstrate
that Southern manufacturers could
attract capital and develop the management and labor skills necessary to
grow and prosper.
While agriculture would continue
to dominate North Carolina’s economy for years to come, the state would
benefit greatly from the economic
diversification that manufacturing
offered. As the most industrialized
state in the South, North Carolina was
considered a model for other Southern
states to follow in promoting industry
and economic development.

Manufacturing meant progress in
North Carolina in the late 19th century.
In the decades following Reconstruction, civic and business leaders, in
almost frenzied tones, touted the
advantages of manufacturing in creating wealth and prosperity.
Lacking the resources and capital to
emulate many of the successful manufacturing operations in Northern
states, North Carolina manufacturers
looked to what natural resources they
had and added value where they could.
32

Region Focus • Spring 2005

PHOTOGRAPHY: CATAWBA VALLEY FURNITURE MUSEUM, HICKORY FURNITURE MART

The Early Years

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What they had in abundance — and
what they knew — was cotton, tobacco,
and timber. They merged agriculture
with light industry, and by 1880 the
industrial revolution was under way in
earnest in North Carolina. Over time,
three industries — textiles, tobacco
processing, and furniture manufacturing — would become symbols of
progress not only in North Carolina,
but also in the entire South.
Large-scale, mechanized furniture
operations first emerged in the
Piedmont region in the 1880s. Among
the earliest was the White Furniture
Company in Mebane, organized by
brothers David and William White in
1881. With a little cash and a loan from a
family friend, they began producing oak
dining room tables. Known for years as
the South’s oldest maker of fine furniture, White Furniture would remain in
Mebane for more than 100 years.
Another early enterprise was the
High Point Furniture Manufacturing
Company in High Point. It was founded in 1889 by Ernest A. Snow, a lumber
salesman, and local merchants John
Tate and Thomas Wrenn. The High
Point factory was small, amounting to
no more than a two-story shed according to one account, and it produced
mainly wooden beds and sideboards.
But it grew quickly: Total sales were
$75,000 the first year and twice that the
second.
In nearby Thomasville, manufacturers were gaining a reputation for
making good chairs. D. S. Westmoreland operated a factory there in the
1880s, and H. E. Clement founded the
Thomasville Manufacturing Company
in 1895. A Thomasville factory could
turn out as many as 1,500 chairs a day in
the early 1900s. A huge wooden chair,
some 13 feet tall, would be erected on
the main street in Thomasville in 1922,
a monument to its heritage as the
“chair town of the South.”
In the early years, the principal
product was simple oak furniture, sold
primarily in Southern markets at inexpensive prices. Bernhardt’s furniture
company in Lenoir sold thousands of
oak chests and tables that cost less than
$4 each around the turn of the century.

Off the Farm
“Nobody could work a man
harder or longer in a mill than he
worked on the farm or his children
either. Nobody would pay him less
than he made there.”
— Jonathan Daniels
Tar Heels: APortrait of North Carolina,1947

s industrialization began to take hold
in Piedmont North Carolina in the
closing decades of the 19th century, an
increasing number of men, women and
children went to work in textile mills,
tobacco plants, or furniture factories.
Many of them were just off the farm,
attracted by a steady paycheck and the
hope of a better life. For most, life at a
North Carolina factory or mill would turn
out to be a vast improvement over life on
the farm.
It was, without a doubt, hard work in
the new industries in the region. Workers
there put in long hours, often 70 or more
hours per week. And they didn’t make
much — as little as 40 to 50 cents per day
in the 1890s for textile workers and sometimes paid in scrip, redeemable only at
company stores.
But farming during the era seldom paid
at all. Even in good years, North Carolina
farmers barely made ends meet. In bad
years, when crops failed or crop prices were
low, they lost money. For most farmers, the
last few decades of the 19th century were
an interminable stretch of bad years.
Crop prices generally declined in the
late 19th century as the farm sector languished in a protracted depression.

A

A solid oak bedroom suite, consisting
of a bed, dresser, and washstand, was
available from White Furniture for $9.
A manufacturer in what is now Drexel
sold a three-piece suite, with an oak
bureau, washstand, and bed, for $14.50
wholesale.
It was sturdy, inexpensive furniture
intended for a largely rural population
with modest means. “People [in the
state] were dirt-poor,” notes Patricia
Marshall, curator of furnishings and
decorative arts at the North Carolina

Cotton, the indispensable raw material
for the cotton textile industry, fell
sharply in price — from 15 cents per
pound in the early 1870s to 6 cents per
pound in the latter half of the 1890s.
Most farmers lost money growing cotton,
even as mill owners profited and the cotton textile industry flourished. Usually in
debt, with farm land mortgaged, many
North Carolina farmers lost their farms
as well.
Of course, many of North Carolina’s
farmers never had their own land to lose
in the first place. In 1880, more than a
third of the state’s farms were operated
by tenants, who worked someone else’s
land and paid the landowner when the
crops came in. Some paid in cash while
others were sharecroppers who agreed to
share the harvest with landowners. The
vast majority of tenant farmers lived
impoverished lives; many suffered physical maladies from improper diets and
poor health care.
With miserable conditions in the agricultural sector, news of a mill or factory
opening in the region was cause for celebration. Tenant farmers in particular
flocked to the expanding industries in the
state. Men, women, and even children
found employment there. (About a quarter of textile mill workers in 1900 were
children.) While the work was drudgery
and the factory floor often hot and noisy,
they stayed with it.
Once they left, few mill or factory
workers ever returned to full-time farming.
— ROBERT LACY

Museum of History in Raleigh. “They
were just getting back on their feet in
the years after Reconstruction.” Even if
North Carolina manufacturers could
have produced higher-quality furniture
in the early years of the industry, most
of the people in the state could not have
afforded it.
According to the U.S. Census
Bureau, there were 44 furniture-manufacturing establishments in North
Carolina in 1900, producing $1.5 million worth of furniture. Although still

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small compared to the textiles, tobacco,
and lumber industries in the state, the
furniture industry was firmly established at the turn of the century and
growing fast.

Growth: 1900 to 1929
North Carolina’s furniture industry
would realize remarkable success in
the early decades of the 20th century.
The value of furniture manufactured
in the state rose from $1.5 million in
1900 to $56.7 million in 1929, the
highest in the South and sixth among
states nationwide. North Carolina
manufacturers excelled in the pro-

duction of household furniture; they
ranked first in wooden dining room
and bedroom furniture and second in
wooden kitchen furniture by that
time.
What accounted for their success?
Proximity to suitable timber certainly
helped. Oak, yellow poplar, maple,
chestnut, and other hardwoods wellsuited for furniture grew in abundance
in North Carolina and nearby states.
Oak, still the most widely used wood
for furniture in the South in the early
1900s, came primarily from North
Carolina and eastern Tennessee.
Proximity to timber helped hold

raw material prices down; in 1929,
the average cost of lumber used for
making furniture was $40.78 per 1,000
feet in North Carolina. In contrast,
Illinois manufacturers paid $72.68
while those in New York paid $71.77.
With materials costs accounting for
about 45 percent of the total costs of
manufacturing medium-quality furniture, Piedmont furniture manufacturers had secured a substantial cost
advantage over Northern and
Midwestern manufacturers.
North Carolina furniture manufacturers also paid lower wages than
manufacturers in the North. The aver-

Johann Belo. Mordica Collins. John Swisegood. Thomas Day. Unfamiliar
to master craftsman Mordica Collins. By 1820, he was operating his own
names to most of us, but they were all master cabinetmakers in the
shop as a master cabinetmaker. He made desks, chests, cupboards,
1800s. In small shops in the backcountry of North Carolina, they
and chests of drawers, some of which were signed and thus can be
produced the finest furniture around.
easily attributed. A Swisegood piece can bring thousands of dollars at
Many of the most accomplished furniture makers in the region
auction today.
hailed from the Moravian community of Salem. The Moravians were
In the small town of Milton, near the Virginia border, lived Thomas
a religious group that settled in North Carolina in the 1750s. Largely
Day, one of the most impressive of North Carolina’s 19th century
of German descent, they built furniture notable for solidity, simplicity
cabinetmakers. Born in Dinwiddie County, Va., in 1801, he was a free
of design, and careful construction.
African-American who moved to Milton
The Moravians believed that woodin the 1820s. Along with bureaus, tables,
working, pottery making, and metal
chairs, and beds, he built household
crafting, like other daily routines, were
fixtures such as fireplace mantles and
ways of serving God; and many
stair railings.
members of the Salem community
Thomas Day had a reputation for
became expert cabinetmakers, potters,
innovative design, careful construction,
and metalworkers in the 19th century.
and use of mahogany veneers. “He came
“The Moravians were fine
up with designs of his own as well as
craftsmen in the backwoods,” notes
using pattern books and styles of the
Patricia Marshall of the North Carolina
period,” says Marshall. “Other furniture
Museum of History. “They had a unique
makers gravitated to what he was doing
style. There was also some
and copied him.”
sophistication to their work, with their
Families in many of the plantation
use of wood inlays.”
homes in the region, as well as in the
Advertisement from the March 1, 1827
Cabinetmakers were a vital part of
governor’s mansion in Raleigh, had
issue of The Milton Gazette.
the Moravian community because they
furniture or millwork made by Day’s shop.
could build household necessities that would otherwise have to be
By 1850, Day’s furniture-making business was the largest in North
freighted in over land to the somewhat isolated town of Salem. In
Carolina. His shop employed free black, white, and slave laborers. He
addition to such items as chairs, tables, beds, chests of drawers, and
was one of only a handful of North Carolina furniture makers using
desks, they constructed doors and window sashes for houses. Johann
steam-powered tools in 1850 and thus one of the earliest to begin
Belo, who operated a shop in Salem from 1806 to 1827, was but one
the transition to a fully industrial production process.
of many Moravian cabinetmakers of the period.
Laurel Sneed, executive director of the Thomas Day Education
About 20 miles to the south of Salem, in the Abbotts Creek area
Project, notes that Day is considered a major figure of the antebellum
of what is currently Davidson County, N.C., another group of master
era. “He was quite active as an entrepreneur and left behind amazing
craftsmen plied their trade. The most notable of these was John
furniture and interior woodwork. He certainly challenges stereotypes
— ROBERT LACY
Swisegood. He learned cabinetmaking and joinery while apprenticed
about African-Americans of the period.”

34

Region Focus • Spring 2005

PHOTOGRAPHY: THE THOMAS DAY HOUSE

Master Cabinetmakers in the 19th Century: Fine Furniture from the Carolina Backcountry

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age wage in the furniture-manufacturing industry in North Carolina in 1929
was 33 cents per hour. In major furniture-producing states in the North,
wages were generally much higher: 57
cents per hour in New York, 56 cents
per hour in Michigan, and 47 cents per
hour in Pennsylvania.
In addition to receiving lower wages
than their counterparts in Northern
states, North Carolina furniture workers tended to work longer hours.
Piedmont furniture workers in the
1920s typically worked 50 to 55 hours
per week. A 40-hour workweek wouldn’t
become standard until the 1930s.
But compared to farming, the alternative for most North Carolina factory
workers, a furniture factory job was a
step up. Most North Carolina farmers
lived hand to mouth on small farms of
fewer than 100 acres. Many farmers
during the period didn’t even own the
land they farmed; about 45 percent of
North Carolina farms in 1925 were
operated by tenants. Just about any job
at a furniture factory was better than a
hard scrabbled life on the farm.
The existence of a grid of railroad
tracks that provided reliable freight
transportation services in the Piedmont
region also spurred the industry’s
growth. The rail system enabled timber
to be hauled to factories and bulky
furniture to be transported throughout
the region at reasonable costs. There
were direct routes to markets in the
Northeast and South, as well as to a
major seaport at Norfolk, Va., where
furniture could be shipped abroad.
High Point, Hickory, Thomasville,
Lenoir, and Morganton were among the
North Carolina towns with furniture
factories built along the railroad tracks.
Lower costs for labor and raw mate-

rials and easy access to markets allowed
North Carolina manufacturers to
steadily gain market share from competitors in the North and Midwest. In
addition, they benefited from an
expanding market for furniture. Rising
incomes, a growing middle class, and a
home-building boom after World War I
helped fuel prosperity in the North
Carolina furniture industry in the
1920s. Output from North Carolina
factories nearly doubled during the
decade. New factories were built and
improved production methods implemented, in some cases emulating massproduction techniques used in the
automobile industry.
By 1929, more than 16,000 people
were at work making furniture in
North Carolina, up from fewer than
2,000 in 1900. Value added in the furniture industry in 1929 amounted to
$27 million, well below that of the
tobacco or textiles industries, but high
enough to place furniture among the
leading manufacturing industries in
the state.

Economic Progress
In 1930, only a generation removed from
the nascent industry of the turn of the
century, North Carolina furniture manufacturers had every right to be proud of
what had been accomplished. Their factories produced more furniture than
those in any other state in the South,
and they had proven to be worthy rivals
to furniture makers in the North and
Midwest. And they would continue to
grow and prosper. While the Great
Depression caused furniture demand to
drop precipitously in the early 1930s —
retail furniture sales in the nation
declined by 63 percent between 1929
and 1933 — population growth and

North Carolina
Factory-Produced Furniture
(1890 and 1900)
Establishments
Wage Earners
Value of Product
Capital

1890

1900

6
152
$159,000
$126,350

44
1,759
$1,547,305
$1,023,374

SOURCE: U.S. Census Bureau, 1900

Wood Used in Furniture
Manufacturing
(1909 to 1913)
Percentage

Oak
Gum (red, tupelo, and black)
Yellow poplar
Southern yellow pine
Chestnut
Maple
All other woods

64.0
12.2
10.6
4.4
2.6
1.4
4.8

SOURCE: C.F. Korstian. The Economic Development of the
Furniture Industry of the South and Its Future
Dependence Upon Forestry. Raleigh: North Carolina
Department of Conservation and Development, 1926

rising incomes in the 1940s and afterward fostered long-term growth in the
industry.
Fifty-five hour workweeks and
33 cents per hour earnings may not
sound like much progress today. But
North Carolina’s furniture industry
helped lead the way in the industrial
development of the South in the early
decades of the 20th century. The Rip
Van Winkle state, as it was sometimes
called in the 1800s for its backwardness
and seeming indifference to social and
educational reforms, was at the forefront of the economic progress that
would eventually bring higher standards of living to the South.
RF

READINGS
Bivins, John, Jr., and Paula Welshimer. Moravian Decorative Arts in
North Carolina: An Introduction to the Old Salem Collection.
Winston-Salem, N.C.: Old Salem, Incorporated, 1981.

Lefler, Hugh T., and Albert R. Newsome. North Carolina:
The History of a Southern State. Chapel Hill, N.C.:
University of North Carolina Press, 1963.

Hobbs, S. Huntington, Jr. North Carolina: An Economic and Social
Profile. Chapel Hill, N.C.: University of North Carolina Press, 1958.

Lemert, Ben F. “Furniture Industry of the Southern Appalachian
Piedmont.” Economic Geography, April 1934, vol. 10, no. 2,
pp. 183-199.

Lacy, Robert. “Whither North Carolina Furniture
Manufacturing?” Federal Reserve Bank of Richmond
Working Paper no. 04-07, September 2004.

Visit www.richmondfed.org for links to relevant sites.

Spring 2005 • Region Focus

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INTERVIEW
Thomas Schelling
Editor’s Note: This is an abbreviated version of RF’s conversation with Thomas Schelling. For the full interview, go to
our Web site: www.richmondfed.org.
Thomas Schelling’s early research was common fare
for economists in the 1950s. The quality of the work
may have been higher than most, but the topics
were relatively mundane. His first two books were
titled simply National Income Behavior and
International Economics. But his interests extended
beyond the traditional confines of the discipline, a
point that was made clear with the publication of
The Strategy of Conflict in 1960. In it, he used the
tools of economics to illuminate important issues
in international relations, while making significant
contributions to game theory and laying the groundwork for later research in experimental economics.
Schelling has continued to publish on military
strategy and arms control throughout his career,
but his work has led him to a number of other
seemingly disparate issues, such as racial segregation, organized crime, and environmental policy. In
each case, he has been able to generate original
insights from ordinary observation. As his longtime colleague Richard Zeckhauser has written,
Schelling “thinks about the essence of phenomena.
In scanning everyday behavior, he sees patterns and
paradoxes that others overlook.”
Schelling spent most of his career at Harvard
University, before joining the faculty of the
University of Maryland in 1990. He is a past president of the American Economic Association and
recently worked with other distinguished economists on the Copenhagen Consensus, a project
designed to prioritize the largest social problems
facing the world. Aaron Steelman interviewed
Schelling at his home in Bethesda, Md., on
February 7, 2005.
36

Region Focus • Spring 2005

RF: Your early work focused on topics that were fairly
conventional. How did your work progress into areas,
such as strategic bargaining, that largely had been
beyond the scope of economists?
Schelling: In 1948, I had just finished my coursework for
the Ph.D. at Harvard, and a friend of mine called from
Washington. He was working on the Marshall Plan and said
that he had an opportunity to go to Paris but he couldn’t
leave until he had a replacement. So he asked me if I would
like to replace him. I said sure.
Eventually, I went to Europe as part of this assignment
and worked mainly on negotiations for the European
Payments Union. Then, Averell Harriman, who had been
head of the Paris office, went to the White House to be
President Truman’s foreign policy advisor. Harriman asked
my boss to go with him, who in turn asked me a few months
later to join him. In 1951, the foreign aid program was shifted to the Mutual Security Program, with Harriman as
director, in the Executive Office of the President. I moved
there, and stayed through the first nine months of the
Eisenhower administration. So when I left, I had spent five
years in the foreign aid bureaus, largely working on negotiations. That, I believe, was what focused my attention on
the type of issues that showed up in The Strategy of Conflict.

RF: One of the more famous bargaining situations that
you propose in The Strategy of Conflict involves a problem in which communication is incomplete or impossible — the game where two strangers are told to meet in
New York City but have not communicated with each
other about the meeting place. What does this game tell
us about bargaining? And what, if any, are the policy
implications?
Schelling: That little exercise, which I designed to determine if people could coordinate without any communication, became fairly famous and now I am usually identified
as the originator of the idea of “focal points.” My argument was that in overt negotiations something is required
to get people to arrive at a common expectation of an outcome. And the ability to reach such a conclusion without
communication suggested to me that there was a psychological phenomenon, even in explicit negotiations, which
may work to focus bargainers eventually on that commonly
expected outcome. By understanding that, I thought, we
may be able to more easily facilitate policy negotiations
over such matters as what would be an appropriate division
of the spoils, an appropriate division of labor, and so forth.

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:12 PM

portation. That narrowed the
list down to the town hall or
the main police station or the
main post office.
Well, before we left home,
we had each given our mothers a list of cities in which we
would look for mail, and the
way you get mail when you
are traveling across country is
to have the letter sent to your
name, care of general delivery, and it arrives at the main
post office in that city. That
occurred to all three of us,
and if we had to choose
among the places that shared
the criteria we described, the
main post office seemed to
be the obvious choice.

RF: What were the responses when you originally posed
this question to people?
Schelling: When I first asked
that question, way back in the
1950s, I was teaching at Yale.
A lot of the people to whom I
sent the questionnaire were
students, and a large share of
them responded: under the
clock at the information desk
at Grand Central Station.
That was because in the 1950s
most of the male students in
New England were at men’s
colleges and most of the
female students were at
women’s colleges. So if you
had a date, you needed a place
to meet, and instead of meeting in, say, New Haven, you
would meet in New York.
And, of course, all trains went
to Grand Central Station, so you would meet at the information desk. Now when I try it on students, they almost
never give that response.
Some cities have more obvious focal points than others.
For instance, if I asked people where would you meet in
Paris, they probably would have no
trouble. Most would go to the Eiffel
Tower. But in other cities, it’s not so
clear.
The question first occurred to
me while I was driving across country with two college friends. We
were going from San Diego to New
Hampshire and back, and camping
along the way. We stopped in San
Antonio and one of the other two
guys got out and bought some
peanut butter and crackers. While
he was gone, a police officer made me move on, and
because of the one-way streets, it took me about 10 minutes to get back to where I dropped him off, and he wasn’t
there. I kept circling around and eventually we found each
other. But we realized that this could happen to us in any
city, and we should come up with a plan about how to meet
if we got separated.
We spent the whole afternoon thinking about it individually, but not talking about it, and that evening around the
campfire we compared notes. We all wound up in the same
place. The criteria we used were the following: Every city
had to have this place and there could be only one of it, you
had to be able to find it by asking any police officer or fireman, and you had to be able to reach it by public trans-

RF: You begin many of your
papers with examples that
are taken from everyday
life. For instance, in “Hockey Helmets, Daylight Saving,
and Other Binary Choices,” you use the case of a player
for the Boston Bruins who suffered a severe head injury
to demonstrate why some collective action problems
can be so difficult to solve — in this case, getting
hockey players to voluntarily
wear helmets. Is this a conscious strategy of yours to
engage readers in what otherwise might seem like an abstract
discussion?

I consider myself in
the rational-choice
school, absolutely. But
I am more interested
in the exceptions than
many other economists.

RF: You have written that the “ordinary human being
is sometimes … not a single rational individual. Some
of us for some decisions are more like a small collectivity than like the textbook consumer.” Could you
explain what you mean by this, perhaps through a few
examples?

Spring 2005 • Region Focus

PHOTOGRAPHY: SCOTT SUCHMAN

Schelling: I always try to find
something that I can put in the first
paragraph to make the article
sound interesting. It was just a
coincidence that the hockey player
had been hit in the head and that
I had noticed it. It was a good example of a scenario in which
everyone might wish to be compelled to do something that
they wouldn’t do on their own individually. So I think that has
been part of my style. I wrote a textbook in international economics that had about a dozen policy chapters. I tried to have
the first page of every chapter present an interesting puzzle or
phenomenon that would get the interest of the readers.

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Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

Schelling: I started working on that subject in the 1970s
when I was asked to join a committee of the National
Academy of Sciences on substance abuse and habitual
behavior. I was the only economist there. Everyone else was
a specialist on a certain type of addictive substance such as
heroin or some other health problem like obesity. It seemed
to be taken for granted that if you were addicted -- whether
to heroin or alcohol or nicotine — there wasn’t much you
could do for yourself. I argued that this was not the case,
and gave a number of examples of ways people can help
themselves avoid relapse.
For instance, one person tried to show how addictive
heroin was by pointing out that many former users, even
those who had avoided heroin for a long time, would be
likely to use the drug again if they were to hang out with the
people they used to shoot up with or even if they listened to
the same music that they played when they used heroin in
the past. I pointed out that there was some instructive
material right there. Don’t associate with the same people.
Don’t listen to the same music. And if the place where you
used to use heroin is on your way to work, find a different
route. So even though those people may be inclined to use
heroin again, there were clearly some ways in which they
could help prevent themselves from having a relapse.
The more I thought about this issue, the more I began
to conclude that a lot of people have something like two
selves — one that desperately wants to drink and one that
desperately wants to stay sober because drinking is ruining
his life and his family. It’s as if those people have two different core value systems. Usually only one is prominent at a
given time, and people may try to make sure that the right
value system attains permanence by taking precautions that
will avoid stimulating the other value system.

RF: Some have called you a “dissenter” from mainstream
economics. But it seems to me that this is true only insofar as it concerns topics of inquiry. On methodological
issues, you don’t seem as willing to abandon some of the
core assumptions of neoclassical economics as, say, those
people who call themselves “behavioral economists.” Do
you think that this is a fair characterization?
Schelling: This is something that I talk about a lot. I claim
that we couldn’t do without rational choice. But we don’t
expect rational choice from a child or an Alzheimer’s patient
or someone suffering from shock. We will better understand
the uses and limits of rational choice if we better understand
those exceptions. I use the example of the magnetic compass.
It’s usually a wonderful way to determine which direction
north is. But if you are anywhere near the actual north magnetic pole, the compass could point in any direction, even
south. The same is true with rational choice. It is a wonderful
tool if used when appropriate, but it may not work all the
time. So I consider myself in the rational-choice school,
absolutely. But I am more interested in the exceptions than
many other economists tend to be.

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Region Focus • Spring 2005

As for the behavioralist critique of neoclassical economics, I
would conjecture that if you walked into a classroom where a
behavioralist is teaching microeconomics, that person would
teach it in a straight, standard fashion. It’s something that you
have to master — you can’t do without it. For instance, if a student
were to ask about the effect of a gasoline tax on driving behavior,
the response would likely be that such a tax will tend to lower consumption of gasoline and/or increase the desirability of more fuel
efficient cars. That’s just straight neoclassical economics.
More generally, I think that when a new idea develops, it is
important that the enthusiasts are given free rein to explore
and perhaps even exaggerate that idea. Once it catches on and
becomes respectable, then it’s time to become more critical.
Rational choice has gone through that process, and the behavioralists have emerged to challenge some of its assumptions.
The behavioralists have probably overstated their case, but
their ideas are relatively new and will be critiqued as well.
I think that people like Dick Thaler and Bob Frank, who are
clearly two of the most innovative behavioralist economists
today, so much enjoy what they do that I’m not sure if they consciously exaggerate the role of these exceptional situations.
When I read Bob Frank, I get the sense that he is passionate,
almost emotional about his belief that American consumers are
suffering welfare losses because they are spending their money
trying to avoid the discomfort of not being equal to their neighbors. I think he overdoes it, and I think that I have told him so.
I don’t know if his answer today would be, “Of course I overdo
it. I’m trying to get attention paid to something I think is
important.” Or if he would say instead, “No, I don’t overdo it. I
really do believe that the phenomenon is that important.” But
even if the former is true, I would excuse that. I think that the
point is important enough that if exaggeration will help them
get it across, let them exaggerate.
RF: What is your opinion of modern game theory?
Schelling: That’s a hard one, because I don’t keep up with all
the latest work in that field. But I would like to make the fol-

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

ry is one that didn’t happen.” I think
lowing broad claims: Economists
you have to go through the history
who know some game theory are
to understand it fully. In the early
much better equipped to handle a lot
➤ Present Position
1950s, it was believed that the likeliof important questions than those
Distinguished University Professor,
hood of the United States using
who don’t. But economists who are
Department of Economics and School
nuclear weapons was so great that
game theorists tend to be more interof Public Affairs, University of Maryland
the Prime Minister of Great Britain
ested in the mathematics aspect of
➤ Previous Faculty Appointments
came to Washington with the
the discipline than the social sciences
Harvard University (1958-1990) and Yale
express purpose of persuading the
aspect. Some economists of the latUniversity (1953-1958)
Truman administration not to use
ter group are good at using their thethem. And because the British had
oretical work to examine policy
➤ Government Experience
been partners in the development of
issues. Still, many — and I think this
The White House and Executive Office
nuclear weapons, their Parliament
is especially true of young game theof the President (1951-1953); Economic
thought that the Prime Minister
orists — tend to think that what will
Cooperation Administration in Europe
had a good right to share in any decimake them famous is their mathe(1948-1950); U.S. Bureau of the Budget
sion about how they would be used.
matical sophistication, and integrat(1945-1946)
ing game theory with behavioral
As we know, they were not used,
➤ Education
observations somehow will detract
but the Eisenhower administration
A.B., University of California at Berkeley
from the rigor of their work.
repeatedly asserted that nuclear
(1944); Ph.D., Harvard University (1951)
I’ll give you an example. I had a
weapons were just like any other
student at Harvard named Michael
type of weapon, and that they could
➤ Selected Publications
Spence, who a few years ago won the
be used as such. The attitude in the
Author or co-author of several books,
Nobel Prize. Mike wrote a fascinatKennedy and Johnson administraincluding The Strategy of Conflict (1960);
ing dissertation about market incentions was quite different. They
Micromotives and Macrobehavior (1978); and
tives to engage in excessive competibelieved that nuclear weapons
Choice and Consequence (1984)
tive expenditure. I was on his comwere fundamentally different, and
➤ Awards and Offices
mittee, and I argued that he needed
their statements helped to build
Fellow, American Academy of Arts and
to do two things. First, summarize
the consensus that their use was
Sciences; Member, National Academy of
the theory in 40 pages. Second, find
taboo — a consensus that may have
Sciences; Past President of the American
six to 10 realistic examples to illusdissuaded Nixon from using them
Economic Association and Eastern
trate how the theory worked and why
in Vietnam.
Economic Association
it mattered. He spent much of a year
Also, in the 1960s there was a
doing that. But in the end, he pubgreat
fear
that
dozens
lished the 40-page version of his dissertation in a top-tier
of countries would come to possess nuclear weapons.
journal, and used that paper as the first chapter of a book.
But the nonproliferation efforts were vastly more successBoth of them got a lot of attention, and led to his appointful than most people expected. It was thought that
ment to the Harvard faculty.
Germany was bound to demand them, and that the
The reason that I advised him to take this approach
Japanese couldn’t afford to be without them. And then it
was quite simple: If he didn’t, other people would and
would spiral down to other countries: the Spanish, the
they would get credit for his work because they were able
Italians, the Swedes, the South Africans, the Brazilians
to apply it to real-world questions. I think that other
would all have nuclear weapons. The process by which
economists, especially young game theorists, can learn
these countries would acquire them, it was thought, was
from this example. Even very technical work often can
through nuclear electric power — the reactors would
be used in an applied manner — and this can benefit the
produce enough plutonium to yield weapons. For several
work as well as the economist.
reasons, that didn’t occur.
Israel’s restraint in the 1973 war was also very important,
I think. Everyone knew that Golda Meir had nuclear
RF: In 1950, few people would have predicted, I think,
weapons, and she had perfect military targets — two
that the Cold War would end as peacefully as it did. For
Egyptian armies north of the Suez Canal, with no civilians
example, it is surely notable that the conflict ended
anywhere near. But she didn’t use them. Why? Well, you
without the use of nuclear weapons. Why do you think
could say, quite reasonably, that they didn’t want to suffer
both sides avoided using means that would have had fairworldwide opprobrium. I think, though, that there was
ly certain, but catastrophic, consequences?
probably another reason. She knew that if she did, the
Iranians, the Syrians, and other enemies of Israel would likeSchelling: I have written and lectured about this quite a bit.
ly acquire them and would not be reluctant to use them. In
When I give a talk on the subject, I begin by stating, “The
addition, it was not clear in the late 1970s that the Soviets
most important event of the second half of the 20th centu-

Thomas Schelling

Spring 2005 • Region Focus

39

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shared the nuclear taboo. Yet, they didn’t use them in their
war against Afghanistan — and this was also very important.
There is a possibility that nuclear weapons will be used in
the India-Pakistan dispute. But I’m not especially worried
about that. The Indians and the Pakistanis have been
involved in nuclear strategic discussions in the West for
decades. They have had a long time to think about this, and
have watched the U.S.-Soviet negotiations. I think they
know that if they were to use nuclear weapons it could easily
lead to something beyond their control. So I think that
by now the taboo is so firmly entrenched, that it is very
unlikely we will see nation-states use nuclear weapons. What
we don’t know is if that taboo holds for non-state actors.
I think that it might, but I don’t hold that opinion with
much conviction.
RF: Some policymakers and analysts have argued that
diplomacy is much more difficult in today’s world than
it was during the Cold War because there are now
multiple non-state players who
seem to place less value on stability than the Soviets did. How
does this change the bargaining
game? How can economics
inform the current conflict with
Islamic terrorists?

terrorists who were willing to sacrifice themselves. Each of
those could have been the principal objective, or there
could have been some combination of objectives. But we
don’t know for sure.
When we think about weapons, many people seem to
think that terrorists will use whatever weapon they can get
their hands on. But consider the use of, say, smallpox from a
cost-benefit analysis. They could release smallpox in New
York, Chicago, and San Francisco. But smallpox is a very
difficult disease to contain in a world of global travel, and
the United States is the country best equipped to deal with
an outbreak. Releasing smallpox in the United States, then,
could result in many more deaths in poor countries with relatively bad health systems like Indonesia and Pakistan than
in the United States. I’m not sure that would be a result the
terrorists would welcome. By unleashing such widespread
death in the developing world — especially in places where
they enjoy support today — they could substantially reduce
their approval and assistance from people who are now
their allies. In contrast, anthrax
might be a more attractive option
because it is not contagious, and
its effects could be limited to the
United States.
Also, there may be a cultural
aspect to this. If releasing a noncontagious toxin in, say, a subway
station is considered by large parts
of Islamic culture to be a cowardly
way to attack your enemy, then this
could be costly to them. It could damage their support in
the same way that releasing a contagious toxin could, even
though the effects of the actual attack would be much more
direct and localized.

The most important
event of the second
half of the 20th
century is one that
didn’t happen.

Schelling: One big difference is
that you simply don’t know who
the non-state actors are. We have
made a big deal out of Osama bin Laden. But we don’t
know if he is alive, and if he is alive, whether he still controls the money and organization in the way that he did a
few years ago. Also, there are no recognized private channels of communication with non-state actors. If you want
to get a message to bin Laden, you either hold a press conference and hope that he will hear it, or send it to him
through a secret private channel.
Also, there is a popular notion that deterrence will not
work when you are dealing with non-state actors. But I’m
not so sure that this is the case. Consider the Taliban. I
think that if the leaders of the Taliban had known what type
of response the attacks of Sept. 11 would produce from the
United States, they would have tried to prevent the attacks.
So I think that we should consider what we can do to alienate bin Laden from some of his supporters. You also need to
consider what types of weapons they are likely to use and
what types of targets they are likely to choose. And we need
to determine their objectives.
For instance, we still don’t know what the objectives
were of the attacks on the World Trade Center, because the
effects were so widespread. It killed a lot of people. It produced the largest media coverage of a terrorist attack in history. It demonstrated U.S. vulnerability, while also destroying a symbol of Western capitalism. And it demonstrated
the competence and some would say the bravery of the

40

Region Focus • Spring 2005

RF: I would like to talk about your famous checkerboard
example as it applies to racial segregation. You have written, “A moderate urge to avoid small-minority status may
cause a nearly integrated pattern to unravel, and highly
segregated neighborhoods to form.” Could you describe
how this process unfolds?
Schelling: When I started thinking about this question,
many American neighborhoods were either mostly white or
mostly black. One possible explanation for this, of course,
was rampant racism. But I was curious about how this might
emerge in a world where racism was not particularly acute,
where in fact people might prefer racial diversity.
The process works basically like this. Let’s say the racial
composition of a neighborhood is 55 percent white and 45
percent black, and that the majority population in the surrounding areas is utterly without prejudice. Then you may get
a case where more and more members of the majority group
move in. This may be fine with the minority group for a
while. They may not mind going from being 45 percent of the
population to 35 percent. But at some point — say, when their

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

part of the population is only 20 percent — then the most
sensitive members of that group will probably evacuate,
reducing their percentage even further. The result is a highly
segregated neighborhood, even though this wasn’t the intent
of the majority population.
I wanted to come up with an easily understandable mechanism to explain this phenomenon that I could use in teaching a class. I spent several summers at the RAND
Corporation, which had a good library. I looked at several
sociological journals, trying to find something I could use,
but I wasn’t able to find anything suitable. So I decided I
would have to do something myself.
One day, I was flying home from somewhere and had
nothing to read. So I passed the time by putting little “X”s
and “O”s in a line, with one group representing whites and
the other representing blacks, and used the assumption that
there was a moderate desire to avoid becoming part of a very
small minority group. Well, it turned out that this exercise
was very hard to do on paper, because you had to keep erasing and starting over.
But my son had a coin collection at the time, and he had a
bunch of copper coins and a bunch of zinc coins. I laid them
out, and then I decided that putting them in a line wasn’t
good enough. You needed more dimensions. So I arranged
them on a checkerboard. I got my 12-year-old son to sit down
at the coffee table with me, and we would move things
around. Soon, we got quite used to how it worked and how
different the results were if one group was more discriminating than the other or if one group was more numerous than
the other.
I published my results, and it got quite a bit of attention at
the time. But it wasn’t until 25 years later that I realized that
this game had pioneered some of the work in what is called
“agent-based modeling” and which is used in a variety of disciplines in the social sciences. At the time I was working out
this example I didn’t realize that I was engaged in an area of
research that would one day have a formal name.
RF: How did you become involved with the Copenhagen
Consensus and what type of policy proposals has the
group offered?
Schelling: I don’t know precisely why I was chosen. Bjorn
Lomborg, the organizer of the project, wanted to gather a
group of economists of some reputation, and he probably
knew that I had written about the greenhouse gas issue. So
that was probably the connection.
When the project started we had a United Nations list of
global problems related mostly to development and poverty.
We were asked to look over that list and pick 10 that we
thought would be worth pursuing. We did that, and then we
asked a very distinguished person in that field to write a
major paper on the issue, along with two other people to
write critiques of the paper.
Somewhere along the way, we began to emphasize an idea
that wasn’t clear to me at the outset and that I think wasn’t

clear to many other people — namely, that this was mainly a
budget priority exercise. We were supposed to do cost-benefit analysis. We were told that we had $50 billion to spend,
and we should decide which projects would provide the most
welfare benefit for the money.
Unfortunately, that approach had not governed our choice
of projects and had not governed the way the papers were
written. For instance, no one really had a good idea of what
you could do with some part of $50 billion to generate more
liberal trade. The same was true with education. The papers
argued that unless you can reform the educational systems in
the big industrialized countries, more money won’t help.
Similarly, it wasn’t clear to us how more money would help us
prevent the spread of financial crises. So we had about five
topics that really did not fit, and we treated many of them as
not applicable. In retrospect, I think we should have treated
climate change in the same way.
Of those projects where we could see how the expenditure
of money would help, restricting the spread of HIV and
AIDS seemed like it should be at the top of the list. It is just
so crucially important that we advocated spending about half
of the money on it. Then there were some projects, like malnutrition and malaria control, where you just got so much for
your money, that we put them near the top also. Projects to
improve sanitation also were deemed quite worthwhile.
In general, I think that the program was successful in
some ways and less successful in others. And if we had it to do
all over again, I think that we could do an awful lot better.
RF: How did you come to the University of Maryland?
Schelling: In the 1980s, Congress passed a law making it
illegal for most businesses to have a mandatory retirement
age for most employees. But they allowed colleges and universities a seven-year grace period. Harvard, at the time, had
mandatory retirement at 70, and I was going to be 70 before
the grace period expired. Well, I was in good health, felt that
there was more research that I wanted to do, and still
enjoyed teaching. So I let it be known that I could be
attracted to another university. My first preference was a
university in Southern California, where I grew up. But then
a former colleague and a very good friend of mine who was
dean of the University of Maryland’s School of Public
Affairs called, and I told him about my situation. He asked
me not to accept another offer until I heard from him. It
also turned out that the chairman of the economics department had been my teaching fellow at Harvard in the 1960s.
So I had two very close connections at Maryland, and I also
knew a few other people on the faculty, like Mancur Olson.
Plus, as we have discussed, much of my work is very policyoriented, which made the Washington area pretty desirable
to me. Overall, it seemed like this would be a good fit for me,
so when the president of the university made me a very generous offer, I accepted it. I have been at Maryland since
1990. I still teach a class or two, but I am now in an
emeritus position.
RF

Spring 2005 • Region Focus

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BOOKREVIEW
America the Unusual
FIGHTING POVERTY IN THE U.S. AND EUROPE: A WORLD OF
DIFFERENCE
BY ALBERTO ALESINA AND EDWARD L. GLAESER
NEW YORK: OXFORD UNIVERSITY PRESS, 2004, 250 PAGES
R E V I E W E D BY A A RO N ST E E L M A N

n 1906, the German economist Werner Sombart
famously asked, “Why is there no socialism in the
United States?” In the century since Sombart posed
that provocative question, numerous social scientists have
offered their own answers. Most notable is the sociologist
Seymour Martin Lipset, who has spent much of his career
trying to explain what he calls “American exceptionalism.”
Yet no one has been able to provide a definitive answer.
Part of the problem is multicausality. People generally
agree that there are several factors at work. But it’s not
clear which factors are most important, or what combination of factors provide the most reasonable answer.
In Fighting Poverty in the U.S. and Europe: A World of Difference, Harvard University economists Alberto Alesina and
Edward Glaeser bring the tools of modern economics to
bear on a similar question: Why do European countries
typically have significantly larger welfare states than does
the United States?
They begin their discussion with a brief recap of some
of the relevant facts. Government expenditures in the
United States are equal to roughly 30 percent of gross
domestic product (GDP), compared to about 45 percent
for continental Europe as a whole
and more than 50 percent in some
individual European states, such as
Sweden. Much of the difference in
the figures can be attributed to
Europe’s more generous social welfare programs, which on net tend to
shift income from the wealthy to
the poor.

I

Economic (Non) Factors
Like their predecessors, Alesina and
Glaeser find that there are multiple
reasons for such cross-Atlantic differences. But somewhat to their surprise, they conclude that those variables which economists might
expect to lead to more redistribution
of wealth do not have much explanatory power.
42

Region Focus • Spring 2005

For instance, one might surmise that there would be
more demand for redistribution in countries with high levels of pretax inequality in order to reduce the dispersion in
wealth. But the United States, by any measure, has significantly greater pretax inequality than continental Europe.
So if this argument were correct, we would see more redistribution in the United States, when in fact we see the
opposite.
A similar argument is that demand for redistribution
could be determined by social mobility. Those countries
that tend to see smaller shares of their populations move
up the income distribution over the course of their lives
might seek a more active role for the state in the economy.
This argument has some empirical support. Members of
the middle class in the United States tend to be more
upwardly mobile than the European middle class. But
when you look at the poorest members of society, the situation is quite different. Europeans living in poverty are
more likely to improve their economic standing over time
than are the poor in the United States. As a result, Alesina
and Glaeser are “led to believe that the differences
between the United States and Europe are not the result of
greater American mobility.”
Another possible economic explanation for Europe’s
greater level of income redistribution could depend on
the relative efficiency of tax systems. If European tax
collection produced smaller social losses, then the cost
of the welfare state would be lower. Alesina and Glaeser
reject this argument with the following, almost rhetorical question: “Could it really be
possible that the tax collectors in
Italy are so much more effective
than the American Internal Revenue
Service?”
Finally, the authors consider economic stability as a possible reason.
The welfare state is often seen as
protecting people from sudden
changes in the economy. So you
might expect that places where economic ups and downs are more frequent or severe would have larger
welfare states. But the variability of
growth and unemployment rates is
greater in the United States than in
Europe. Yet, as we have seen, the
U.S. welfare state is considerably less
generous, making this argument
implausible.

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

Political Factors
“Our examination of explanations which we labeled as purely
‘economic’ has left us almost completely empty-handed,”
Alesina and Glaeser conclude. They turn next to what they
label “political” explanations — those that “emphasize the
state, the political arena, and political institutions” — and
here they find more success.
At first, this may not seem like a very fruitful area of
inquiry. After all, the United States and the countries of continental Europe that Alesina and Glaeser examine are all liberal
democracies. How, then, could those countries’ political systems explain the difference in the sizes of their welfare states?
The answer is that most European democracies have significantly different rules for implementing public policies
than does the United States. In particular, most European
states have systems of proportional representation that
make it possible for fringe parties, such as the Socialist and
Communist parties, to gain entry
to the political system and build
coalitions with more mainstream
left-of-center parties. Once in
power, the fringe actors often can
influence the platform of the broad
left-wing coalition, pushing it to
adopt more radical proposals,
which lead to greater redistribution of income.
In contrast, the American winner-takes-all system tends
to encourage candidates to move more closely to the positions of the median voter, as the economist Anthony Downs
explained in his seminal 1957 book An Economic Theory of
Democracy. Such a system makes it difficult for third-party
candidates to win office, or even for more ideologically
extreme candidates within a major party to gain power.
Consider that of the 435 members of the U.S. House of
Representatives, 434 belong to one of the two major parties.
Bernie Sanders of Vermont, an Independent, is the only
exception.
But this begs the question: What caused the states of continental Europe to adopt systems of proportional representation? After all, those systems are relatively new, with most
being adopted in the 20th century. Alesina and Glaeser offer
two explanations.
First, labor strikes in the early 1900s effectively shut down
economic life in the smallest states of continental Europe
(Belgium, the Netherlands, and Switzerland) as well as in
those states where the population is highly concentrated in
one or two cities (Finland and Sweden). As a result of these
crippling strikes, the labor movement was able to effectively
push for electoral reform. Second, in many of the larger states
of continental Europe (Austria, Germany, and Italy), systems
of proportional representation were adopted following World
War I, when those countries were in economic and political
disarray. So although the United States is a much “newer”
country than most of the states of continental Europe, its
political institutions tend to be significantly older and more

stable. Perhaps most important, they are designed to make
radical change relatively difficult to achieve.

Race and Ideology
Alesina and Glaeser argue that race also can help explain differences in the American and European welfare states. The
United States is a much more diverse society than any of the
countries of continental Europe, and in America poverty
tends to be highly concentrated among minority groups. “As a
result, it is much easier to convince a white middle-class person in the United States to think that the poor are ‘different’
(read black) than to convince a white middle-class person,
say, in Sweden,” Alesina and Glaeser write. Such “racial divisions and racial preferences appear to deter redistribution,”
they conclude.
This argument may generally be correct. But one is left
wondering how the passage of Great Society programs, which
greatly expanded America’s welfare
state, fits into this story. Those programs, of course, were passed in the
mid-1960s, as the Civil Rights
struggle also was gathering steam.
It’s true that widespread backlash
against those programs, as well as
laws that helped protect civil rights,
arguably cost the Democrats support in the South and thus retarded
further expansion of the welfare state. But it’s not clear how
Medicaid and the Department of Housing and Urban
Development, both of which benefited minorities disproportionately, would have passed initially if race was the important factor that Alesina and Glaeser suggest.
Also, the authors may not have paid sufficient attention to
ideology. This is understandable: Ideology is hard to measure.
But it surely was an important factor in explaining why
America’s Founders established the political system they did.
And that is true even if one also accepts, as Alesina and
Glaeser do, that the Founders had a large economic stake in
passing a constitutional structure that placed relatively tight
limits on government. Ideology also helps us understand why
that political system remained largely unchanged during the
Great Depression. The New Deal significantly expanded the
role of the state, to be sure, but America’s fundamental political structure remained intact, even in a time of extreme crisis.

U.S. political
institutions make
radical change
relatively difficult.

Conclusion
At the outset of the book, Alesina and Glaeser inform readers that their “interest is in the explanation of why the welfare state, not in its costs and benefits.” Overall, they have
made an important contribution to this enduring debate.
One hopes that they will now turn their formidable analytical powers toward answering that question which they have
left unaddressed: What have these quite different welfare
states meant for the economic well-being of the United
States and continental Europe? Such a discussion would
make for an excellent companion volume.
RF

Spring 2005 • Region Focus

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DISTRICT ECONOMIC OVERVIEW
BY RO B E RT L AC Y

conomic growth was relatively
strong in most sectors of the
Fifth District economy in the
fourth quarter of 2004. The broad
services sector expanded at a solid
pace as ongoing gains in employment and income drove demand for
services higher.
Housing markets were particularly strong; new home construction
was well above the pace of a year earlier and home prices rose sharply in a
number of District states. Manufacturing was a soft spot, however, as
growth in shipments and new orders
slowed and factory employment
edged lower. Job growth was somewhat stronger in other sectors of the
economy, though, pushing the
District’s unemployment rate down
to 4.6 percent.

E

Services Sector Expands
but Retail Soft
The Fifth District’s services sector
expanded at a brisk pace during
the fourth quarter. Services firms generally reported solid revenue growth
throughout the period. Retailers said
merchandise sales growth was spotty
early in the quarter, but improved in late
December. Sales of automobiles and
other big-ticket retail items, though,
were soft throughout the quarter.

“The Fifth District
economy continued to
expand at a solid pace as
2004 came to a close.”
One of the District’s largest retailers, Richmond, Va.-based Circuit City,
continued to struggle in a difficult
retail environment. In February, it
announced the closing of 19 stores,
mainly in the Midwest, in an effort to
cut costs. A distribution center in
Doswell, Va., will also be closed.

Manufacturing Growth Slows
In order to gauge developments in the
manufacturing sector, the Richmond
Fed now releases a composite manufacturing index. This index more
broadly reflects activity in the sector
by combining what manufacturers tell
us about shipments, new orders, and
employment. The composite index
suggests that growth in manufacturing
activity slowed substantially in the
fourth quarter of 2004. The weaker
readings were the result of lower index
values for shipments, new orders, and
employment during the quarter.

Economic Indicators
Nonfarm Employment (000)
Fifth District
U.S.
Real Personal Income ($bil)
Fifth District
U.S.
Building Permits (000)
Fifth District
U.S.
Unemployment Rate (%)
Fifth District
U.S.

44

4th Qtr.
2004

4th Qtr.
2003

Percent Change
(Year Ago)

13,254
132,294

13,011
130,168

1.9
1.6

870.5
9,152.4

838.2
8,794.2

3.9
4.1

53.4
471.7

49.8
451.8

7.1
4.4

4.6%
5.4%

5.3%
5.9%

Region Focus • Spring 2005

Reports of higher prices for raw
materials were more in evidence
among respondents in October and
November. Steel, plastic, and natural
gas were among those commodities
most frequently mentioned as rising
rapidly in price. But raw material
price hikes eased toward the end
of the year, and prices for finished
goods rose only modestly.

District Job Performance
Bests Nation’s
We track monthly payroll employment numbers closely because these
data are among the timeliest measures
of economic performance available at
the state level.
Fifth District payroll employment
in the fourth quarter was 1.9 percent
higher than a year earlier, a somewhat
stronger growth rate than the 1.6 percent rate of the United States as a
whole. Growth was above 2 percent in
Maryland and Virginia, the two fastestgrowing states in the District. By sector, employment growth continued to
be centered in services.

House Prices Soar
House prices in the District of
Columbia and in parts of Maryland
and Virginia have skyrocketed over
the last year. HUD’s Office of
Federal
Housing
Enterprise
Oversight tracks state-level house
prices on a quarterly basis. According
to their statistics, prices in the
District of Columbia in the third
quarter of 2004 were 23 percent
higher than a year earlier.
Increases in Maryland and
Virginia were 19 percent and 16 percent, respectively. Prices in other
Fifth District states rose at a more
modest 5 percent to 8 percent pace
during the period.

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

Nonfarm Employment

Unemployment Rate

Real Personal Income

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2004

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2004

First Quarter 1992 - Fourth Quarter 2004

4%

8%

3%

7%
6%

7%

5%

2%
6%

4%

5%

2%

1%

3%

0

1%

4%

-1%

0%

-2%
1992

1995

1998

2001

2004

3%

1992

1995

1998

2001

2004

Fifth District

-1%

1992

1995

1998

2001

2004

United States

Nonfarm Employment
Metropolitan Areas

Unemployment Rate
Metropolitan Areas

Building Permits

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2004

First Quarter 1992 - Fourth Quarter 2004

Change From Prior Year

First Quarter 1992 - Fourth Quarter 2004

30%

9%

8%
7%
6%
5%
4%
3%
2%
1%
0
-1%
-2%
-3%

8%

20%

7%
10%

6%
5%

0%

4%
-10%
3%
1992

1995

1998

Baltimore

Charlotte

2001

2004

2%

1992

Washington

1995

1998

Baltimore

FRB—Richmond
Services Revenues Index

2001

Charlotte

2004

-20%

First Quarter 1994 - Fourth Quarter 2004

30

30

20

20

10

10

0

0

-10

-10

-20

-20

1998

2000

2002

2004

United States

House Price Index

MD
NC
SC

(1980 Q1 = 100)
First Quarter 1994 - Fourth Quarter 2004

First Quarter 1994 - Fourth Quarter 2004

40

1996

Fifth District

FRB—Richmond
Manufacturing Composite Index

40

1994

Washington

VA
WV
DC

500

400

300

-30

200
100

-30
1994

1996

1998

2000

2002

2004

1994

1996

1998

2000

2002

2004

1994

1996

1998

2000

2002

NOTES:

SOURCES:

1) FRB-Richmond survey indexes are diffusion indexes representing the percentage of responding firms
reporting increase minus the percentage reporting decrease.
The manufacturing composite index is a weighted average of the shipments, new orders, and employment
indexes.
2) Metropolitan area data and building permits are not seasonally adjusted (nsa); all other series are
seasonally adjusted.

Income: Bureau of Economic Analysis, U.S. Department of Commerce, http://www.bea.doc.gov.
Unemployment rate: LAUS Program, Bureau of Labor Statistics, U.S. Department of Labor,
http://stats.bls.gov.
Employment: CES Survey, Bureau of Labor Statistics, U.S. Department of Labor, http://stats.bls.gov.
Building permits: U.S. Census Bureau, http://www.census.gov.
House prices: Office of Federal Housing Enterprise Oversight, http://www.ofheo.gov.

2004

For more information, contact Robert Lacy at 804-697-8703 or e-mail Robert.Lacy@rich.frb.org.

Spring 2005 • Region Focus

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STATE ECONOMIC CONDITIONS
BY A N D R E A H O L L A N D

s 2004 drew to a close, business conditions in the
District of Columbia continued to show improvement, but conditions of households softened. Businesses
in the District of Columbia continued to tack on jobs in
the fourth quarter. Payroll employment expanded 0.1 percent, marking five consecutive quarters of job growth.
Among sectors, education and health services establishments led the gains, adding 4,300 jobs. By comparison,

A

DC Home Price Growth
24

Annual Percent Change

US

5E

DC

20
16
12
8
4

2000

2001

2002

2003

2004

SOURCE: House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics

construction posted the weakest performance, trimming
733 jobs. Looking ahead, the refurbishment of the
RFK stadium and construction of a new major league
baseball stadium are expected to create 900 new jobs
later this year.
Other recent economic indicators also pointed to an
upturn at businesses. Venture capital inflows into District
of Columbia firms totaled $38 million in the fourth
quarter, the largest quarterly increase in three years.
Moving on, the financial conditions of households
were mixed. The District of Columbia’s unemployment
rate edged up to 8.8 percent in the fourth quarter — the
highest rate since the third quarter of 1998. On a more
positive note, the number of unemployment benefits
claimants decreased in the fourth quarter, following a
slight uptick the quarter before.
Turning to the District of Columbia’s real estate market, home prices reached an all-time high in the fourth
quarter, standing 23.0 percent higher over the year. But
sharply steeper prices didn’t deter buyers — in excess of
18,000 homes were sold during the period, a new record.
Underlying strength was apparent in readings on future
construction as well. Fourth-quarter building permit
authorizations were 3.6 percent above third-quarter levels.
News from the broadly defined Washington, D.C.
MSA was more upbeat than in the District of Columbia
46

Region Focus • Spring 2005

proper. Boosted by a surge in defense and homeland
security spending and an improved outlook at high-tech
related businesses, fourth-quarter payrolls expanded
4.1 percent and the unemployment rate dropped 0.3 percentage points to 3.0 percent.

U Maryland
arometers of Maryland’s economic health were generally bright at the end of 2004. Businesses in the state
continued to add jobs in the fourth quarter, marking two
straight years of positive payroll growth. Gains came
almost entirely from service-providing establishments —
goods producers in the state trimmed jobs during the
period.
Adding to the upbeat tone, venture capitalists infused
$236 million into Maryland businesses in the fourth
quarter, almost tripling the third-quarter inflow and
registering the largest gain in exactly three years. The
most exciting news was that 38.5 percent of the funding
went toward seed stage businesses, leading some analysts
to suggest the beginning of a long-awaited pickup in
investor confidence.
Financial conditions at Maryland households also
brightened. Keeping with stronger payroll growth, the
jobless rate fell 0.3 percentage points to 3.9 percent,
remaining well below the national rate. In contrast,
another indicator of labor force activity — initial jobless
claims — inched higher in the fourth quarter, following
three quarters of improvement.

B

MD Home Price Growth
24

US

Annual Percent Change

District of Columbia

5E

MD

2001

2002

20
16
12
8
4

2000

2003

2004

SOURCE: House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics

Looking at real estate conditions in Maryland, residential activity remained on target, despite a blip in home
sales. Sales of existing homes contracted 0.5 percent in
the fourth quarter, making Maryland the only District
state to record a slowdown during the period. Despite
softer sales, home prices continued to increase with the

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

h

North Carolina

orth Carolina’s economy advanced steadily in the
fourth quarter of 2004. Businesses in the state
continued to expand hiring, causing payroll employment
to expand by 1.3 percent in the fourth quarter — the third
straight quarterly increase. By sector, job numbers picked
up most at government and leisure and hospitality establishments. By comparison, job losses were greatest in the
manufacturing sector, where the broader economic recovery has yet to fully establish itself.
In other business news, the latest numbers on venture
capital investment were very encouraging. Fourth-quarter
inflows totaled $114 million — the largest quarterly
injection in two years. The majority of the capital was
slotted for expansion-stage and later-stage companies.
Household financial conditions remained steady.
Despite the solid gain in payroll employment in late-2004,
the unemployment rate remained fixed at 5.0 percent as
nearly 10,000 new persons entered North Carolina’s labor
force over the period. On a less positive note, the number
of state residents newly applying for unemployment benefits rose by 11.8 percent in the fourth quarter, the second
straight increase.
Switching gears, North Carolina’s
housing market continued to gain
strength in the fourth quarter.
According to the latest data, home
prices rose 6.1 percent in the fourth
quarter. Residential realtors were kept
on their toes — existing home sales
stood 25.4 percent higher in the
fourth quarter compared to a year earlier, marking the strongest annual growth rate districtwide.
Indicators of future construction were not as robust. New
building permits edged 3.0 percent lower in the fourth quarter, following a similar decline in the third quarter.

N

NC Home Price Growth
24

US

Annual Percent Change

median-priced home now 18.6 percent more expensive
than a year ago. Tracking sales activity, building permits
also dwindled in late-2004, but remained 4.8 percent
above a year earlier.
The Baltimore metro area economy continued to outperform the state as a whole. Payrolls rose by a solid
5.1 percent in the fourth quarter, and the jobless rate
plummeted 0.5 percentage points to 4.3 percent. New
construction activity in Baltimore outperformed other
areas of the state — building permits jumped 73.5 percent
from the third quarter. In other news, Baltimore’s commercial real estate market continued to warm, albeit
slowly. Fourth-quarter office and industrial vacancy rates
came in below levels posted a year ago.

5E

NC

20
16
12
8
4

2000

2001

2002

2003

2004

SOURCE: House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics

North Carolina’s metro areas saw steady job growth in
late 2004. In the fourth quarter, Charlotte and RaleighDurham posted payroll employment gains of 11.9 percent
and 3.8 percent, respectively. Likewise, both metros saw a
decline in their jobless rates. In real estate, new construction activity in Charlotte and Raleigh-Durham mirrored
that of the state. Both posted a significant drop in new
building permit authorizations.

o South Carolina
G

oing into 2005, economic momentum was more evident in South Carolina than a year earlier. Business
conditions in the state continued to improve. South
Carolina added 4,176 jobs in the fourth quarter, reversing
a modest third-quarter loss. By category, the leisure and
hospitality sector displayed the most strength — payrolls
increased by 15,267. By comparison, the largest loss was
recorded in the professional and business services sector,
where employment fell by 3,833.
Adding to the positive tone on the business front, venture capitalists injected $12.3 million dollars into South
Carolina firms, the largest quarterly inflow since late
2002. Of this total, more that onethird of the venture funding went
toward a business still in the startup stage, possibly suggesting a
pickup in investor confidence.
The latest data suggested that
households in the state may also
be experiencing a pickup in confidence — the number of job seekers increased by nearly 10,000 in
the fourth quarter. Despite strong job gains, the sizable
increase in the labor force pushed the unemployment
rate up 0.2 percentage points to 6.6 percent. Initial
claims for unemployment insurance in the fourth

“Economic momentum
was more evident in
South Carolina than a
year earlier.”

Spring 2005 • Region Focus

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SC Home Price Growth
24

Annual Percent Change

US

5E

SC

20
16
12
8
4

2000

2001

2002

2003

2004

SOURCE: House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics

quarter rose by 16.2 percent but were attributed mainly
to seasonal factors.
As in other Fifth District states, the median price for a
South Carolina home continued to move higher last year,
rising by 5.8 percent. And the evidence suggests that
demand pulled prices higher. Fourth-quarter existing
home sales were 15.4 percent higher over the year, marking the second strongest growth
rate districtwide. Prospects for
new construction remained on
track — new building permits filed
in the fourth quarter were significantly higher over the year.
Fourth-quarter activity in South
Carolina’s metro areas was mixed.
Payroll employment expanded at a
robust 6.4 percent rate in
Columbia, but Charleston experienced a decline in job
numbers — employment contracted 1.0 percent. New
construction slowed in both metropolises in the fourth
quarter, but as seen statewide, remained well above yearago levels.

ment into Virginia businesses picked up in the fourth
quarter. Capital inflows totaled $73.8 million, nearly double the amount recorded in the third quarter. By stage of
investment, nearly one-fifth of the funds were infused
into seed and startup businesses.
Household conditions also remained on track in the
fourth quarter. The jobless rate dropped 0.2 percentage
points to 3.3 percent, despite an inflow of 11,300 job seekers into the labor market. And although the number of
first-time claimants for unemployment insurance
increased by 20 percent, the level remained below that of
a year ago.
On the real estate front, the latest readings on home
prices suggest that appreciation has continued to heat up.
The state recorded a 10.5 percent jump in the fourth quarter alone. As in other states, the increases appear to result
from strong demand growth, as illustrated by the 3.4 percent increase in fourth-quarter home sales. New construction, however, advanced at a more moderate pace. The
number of building permits issued in the fourth quarter
was somewhat below those recorded in the third quarter.
Economic activity in Virginia’s metro areas also continued to look up, with businesses
in the Norfolk and Richmond
metro areas boosting payrolls by
4.3 percent and 3.0 percent,
respectively. Much of Richmond’s
job growth was centered in education and health services — not a
surprise since the city is home to
several universities and research
hospitals. According to a breakdown of the data, Norfolk’s labor market was boosted by
increased defense and homeland security spending. In
line with strengthening labor markets, the jobless rate
posted healthy declines in both areas.

“In Virginia,
government establishments created the
most new jobs.”

u Virginia
irginia’s economic prospects continued to brighten
as 2004 drew to a close. The state posted the
District’s strongest rate of job growth in the fourth
quarter as well as the fifth strongest nationwide for all
of 2004.
Fourth-quarter payrolls increased by 0.5 percent, or
4,500 jobs, marking the seventh straight quarter of
positive job growth. Among major industries, government establishments created the most new jobs, while
education and health services businesses cut the most
positions.
Mirroring national activity, venture capital invest-

VA Home Price Growth

V

48

Region Focus • Spring 2005

24

Annual Percent Change

US

5E

VA

20
16
12
8
4

2000

2001

2002

2003

2004

SOURCE: House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

est Virginia businesses trimmed jobs in the final
quarter of 2004 — the only Fifth District state to
do so — suggesting that the economic expansion may not
have been firmly entrenched in 2004.
Compared to states across the nation, West Virginia
ranked 41st in terms of job growth in 2004. Fourth-quarter payroll numbers slipped 1.7 percent, with reductions
sprinkled across establishments on the services side of
the economy. In contrast, West Virginia goods producers
added jobs during the quarter.
Other business news was more upbeat — venture capital investment into West Virginia businesses totaled $5.3
million in the fourth quarter, following flat inflows in the
third quarter. Also positive, nearly 60 percent of the
inflows were targeted toward firms in the startup stage.
Moving on, the bounceback at West Virginia households has also been slow to take hold. Mirroring payroll
activity, West Virginia was the only District jurisdiction
to record a contraction in the labor force in the fourth
quarter. The downsizing of the labor market helped facilitate the 0.3 percentage point decline in the jobless rate,
despite falling payroll numbers. Also less encouraging,
initial claims for unemployment insurance rose in the
fourth quarter, reversing three consecutive periods of
improvement.
One bright spot of West Virginia’s economy in recent
years has been real estate, driven in part by historically

W

WV Home Price Growth
24

Annual Percent Change

w West Virginia

20

US

5E

WV

16
12
8
4

2000

2001

2002

2003

2004

SOURCE: House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics

low mortgage rates and relatively affordable housing.
Fourth-quarter home prices expanded at a healthy rate,
by 7.6 percent. Some of the price increase likely stemmed
from playing catch up with surrounding states, as West
Virginia home prices remain the lowest districtwide.
Affordable prices have apparently attracted homebuyers,
though — sales of existing housing units rose by 4.0 percent in the fourth quarter.
Economic activity was a bit more upbeat in the
Charleston metro area than in other areas of the state.
Payrolls in that area continued to move higher, rising 0.6
percent in the fourth quarter. In line with the improvement in hiring activity, Charleston’s jobless rate fell 0.1
percentage points to 4.1 percent.

Behind the Numbers
Maryland added 52,300 to the ranks of the employed in
2004, according to the Labor Department. No wait —
make that 63,800, according to the, er, Labor Department.
What gives? The problem is a simple discrepancy
between two sets of government-generated numbers: the
so-called “payroll” and “household” surveys, from which
monthly U.S. job statistics are derived. The payroll survey
produced the 52,300 employment growth figure mentioned
above, while the household survey came up with the 63,800
number. Sometimes, the differences between the two studies can be even more significant.
In general, economists consider the payroll survey more
reliable. Here’s why.
The payroll survey, also called the “Establishment
Series,” is based on reports from a sample of about 400,000
businesses, covering about a third of nonfarm employment.

By comparison, the household survey uses a sample of
60,000 homes.
One other key difference is that the payroll survey asks
firms how many employees they have, while the household
survey asks people whether they have jobs. For that reason,
some economists say the household survey may be more
effective in capturing the number of self-employed people
in the economy as well as in predicting job growth.
Still, “it’s clear the payroll survey is the preferred survey
for judging changes in business conditions in the near
term,” says Roy Webb, an economist at the Federal Reserve
Bank of Richmond. He adds that, shortcomings notwithstanding, the household survey enjoys broad support from
economists as another tool in their analysis kit. “As an
economic analyst, I always think more data is better,”
Webb says.
— DOUG CAMPBELL

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State Data, Q4:04
DC

MD

NC

SC

VA

WV

Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change

672.3
0.1
1.2

2,538.7
0.5
2.1

3,874.9
1.3
1.8

1,839.0
0.9
1.4

3,595.5
0.5
2.2

733.4
-1.7
1.5

Manufacturing Employment (000)
Q/Q Percent Change
Y/Y Percent Change

2.5
0.0
-2.6

144.2
-0.5
-0.5

576.5
-3.9
-2.2

269.8
-0.9
-1.5

295.0
-0.5
-0.7

63.4
0.0
-0.9

Professional/Business Services Employment (000) 146.9
Q/Q Percent Change
3.0
Y/Y Percent Change
3.4

370.9
-3.3
3.0

447.5
3.3
5.4

188.7
-7.7
0.3

581.5
0.3
4.7

56.5
-3.7
0.3

Government Employment (000)
Q/Q Percent Change
Y/Y Percent Change

231.9
-0.4
0.5

462.7
-2.8
0.7

664.2
6.0
1.6

336.0
1.7
1.2

660.3
3.9
2.9

142.3
-4.9
1.0

Civilian Labor Force (000)
Q/Q Percent Change
Y/Y Percent Change

307.8
9.2
2.3

2,956.9
0.6
1.7

4,187.6
0.9
-1.6

2,082.0
1.8
3.3

3,853.5
1.2
1.8

801.0
-0.8
2.7

Unemployment Rate (%)
Q3:04
Q4:03

8.8
7.8
7.0

3.9
4.2
4.5

5.0
5.0
6.3

6.6
6.4
6.9

3.3
3.5
3.9

5.0
5.3
5.7

Personal Income ($bil)
Q/Q Percent Change
Y/Y Percent Change

27.0
1.6
3.9

205.4
1.6
3.6

236.0
1.5
3.5

107.5
1.3
3.1

250.2
1.7
4.6

44.3
1.7
4.1

Building Permits
Q/Q Percent Change
Y/Y Percent Change

347
15.1
298.9

7,211
-11.5
4.8

20,382
-49.2
4.8

10,677
-5.2
30.0

13,669
-48.4
-2.8

1,082
-70.3
-3.9

House Price Index (1980=100)
Q/Q Percent Change
Y/Y Percent Change

496.2
19.9
23.0

403.4
9.8
18.6

289.3
6.1
5.2

270.7
5.1
5.8

369.3
10.5
16.4

215.2
7.6
8.0

18.1
19.1
8.4

153.4
-0.5
10.1

375.1
4.4
25.4

176.4
4.7
15.4

210.1
3.4
13.1

39.3
4.0
14.2

Sales of Existing Housing Units (000)
Q/Q Percent Change
Y/Y Percent Change

NOTES:
Nonfarm Employment, thousands of jobs, seasonally adjusted (SA); Bureau of Labor Statistics (BLS)/Haver Analytics, Manufacturing, thousands of jobs, SA; BLS/Haver Analytics, Professional/Business Services, thousands of jobs, SA; BLS/Haver Analytics
Government, thousands of jobs, SA; BLS/Haver Analytics, Civilian Labor Force, thousands of persons, SA; BLS/Haver Analytics, Unemployment Rate, percent, SA; BLS/Haver Analytics, Personal Income, billions of chained 2000$, Bureau of Economic
Analysis/Haver Analytics, Building Permits, number of permits, NSA; U.S. Census Bureau/Haver Analytics, House Price Index, Office of Federal Housing Enterprise Oversight/Haver Analytics, Sales of Existing Housing Units, thousands of units, SA; National
Association of Realtors®

50

Region Focus • Spring 2005

Pg 51 KC.ps - 4/29/2005 12:02 PM

Metropolitan Area Data, Q4:04
Washington, DC MSA

Baltimore, MD MSA

Charlotte, NC MSA

2,937.2
4.1
2.7

1,282.3
5.1
2.0

856.6
11.9
2.8

3.0
3.3
3.3

4.3
4.8
4.9

5.2
5.5
6.8

7,866
-57.9
2.1

2,884
73.5
-5.8

4,642
-61.2
3.2

Raleigh, NC MSA

Charleston, SC MSA

Columbia, SC MSA

703.3
3.8
2.3

266.7
-1.0
2.4

307.5
6.4
2.3

3.2
3.3
4.2

4.3
4.6
4.5

4.1
4.3
4.0

3,099
-45.3
-5.8

2,059
-29.5
22.3

1,649
-23.6
44.3

Norfolk, VA MSA

Richmond, VA MSA

750.4
4.3
1.2

575.1
3.0
1.5

134.5
0.6
0.5

Unemployment Rate (%)
Q3:04
Q4:03

4.0
4.4
4.1

3.7
4.2
4.0

4.1
4.2
4.2

Building Permits
Q/Q Percent Change
Y/Y Percent Change

2,621
44.4
-16.8

2,127
-40.3
-1.1

68
-76.8
4.6

Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q3:04
Q4:03
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change
Unemployment Rate (%)
Q3:04
Q4:03
Building Permits
Q/Q Percent Change
Y/Y Percent Change

Nonfarm Employment (000)
Q/Q Percent Change
Y/Y Percent Change

Charleston, WV MSA

For more information, contact Andrea Holland at 804-697-8273 or e-mail Andrea.Holland@rich.frb.org.

Summer 2005 • Region Focus

51

Region Focus Spring 2005 v.6.ps - 4/25/2005 13:13 PM

OPINION
Evil Empire?
BY C H A R L E S G E R E N A

W

uncovered, undermining trust in their companies and leading
e are a nation built on capitalism. Americans value
to criminal investigations of CEOs and CFOs.
progress and venerate the entrepreneurs who
At this point, you may be wondering: “I thought he said big
blaze new trails in the pursuit of profits.
business
wasn’t inherently evil? It sure sounds like that’s the
As a nation born of revolution, however, we also distrust any
case.”
institution that gets too big for its britches. Entrepreneurs from
Well, it isn’t. Once a company reaches a certain size, it can
Andrew Carnegie to Bill Gates became magnets of criticism as
reduce its average total costs over the long run by employing
their once-fledgling companies grew into corporate behemoths.
machinery that is more efficient, dividing processes and
The truth is big business is neither a bully nor a benefactor.
assigning them to specialized workers, and earning discounts
Its goal is to make money. In the process, it tends to serve its
on bulk purchases. Such economies of scale enable companies
own interests as well as those of consumers. However, not all
to lower their prices for goods and services, which benefits the
firms conduct themselves in ways that the public deems
consumer.
socially acceptable.
This alludes to another aspect of becoming big — it is
America’s love-hate relationship with big business predates
often the result of consumers rewarding a company for giving
the appearance of the first Wal-Mart discount store. The late
them what they want. If some firms can satisfy their cus1800s saw the rise of industrial powerhouses like Standard Oil
tomers more effectively than their rivals, they will sell more,
and U.S. Steel. Magnates such as John D. Rockefeller and J.P.
resulting in increased concentration in an industry.
Morgan profited as wealth became more concentrated and
Microsoft, for instance, now controls an overwhelming
fears of diminishing market competition grew.
share
of its market. While the company’s current size may
However, they weren’t supposed to be the only ones made
dampen its incentive to be innovative, who could really think
better off by industrial concentration. This was supposed to be
that we would be better off without
good for society in general. Morgan
its products?
Witzel, in his introduction to an edited
volume titled Big Business and the Muck“Economies of scale enable
Rather than focus on “bigness,”
Rakers, 1900-1910, explains the mindset
perhaps we should think about why
at the time: “Without the need to combusinesses, large or small, go astray. For
companies to lower their prices
pete and spend money fighting off
example, one could argue that excesbusiness rivals, corporations could consive regulation provides an incentive
for goods and services, which
centrate on becoming more efficient,
for companies to seek out shortcuts
reducing costs, and providing cheaper
that skirt the edge of ethical behavior.
benefits the consumer.”
goods to the public.”
Such regulation also may create barriers to entry for new companies.
Things didn’t turn out that way,
though. Many prices didn’t fall and inefficiencies remained.
The more important issue may be the complexity of a comOn top of that, labor unrest increased and scandals over workpany rather than its size. “… Innovative financing techniques
er safety and product quality made the headlines of muckrakhave made it more difficult for outside investors to undering magazines like McClure’s. Also, some companies, particustand a particular firm’s risk profile and the performance of its
larly railroads, used their economic power to garner favorable
various lines of business,” noted Fed Governor Susan Schmidt
treatment by lawmakers.
Bies in a February 2004 speech. “Traditional accounting stanFast-forwarding to the 1980s, corporate raiders like Carl
dards have not kept pace with the risk-management tools
Icahn and Boone Pickens led hostile takeovers of companies
employed by sophisticated corporations.” Bies suggested that
and carved their acquisitions into pieces to sell off at a quick
improved corporate transparency would help market participrofit. While businesses across America consumed a lot of
pants gauge a company’s strategies and actions.
time and money to keep these wolves at bay, some argue that
Ultimately, markets exist to optimize the use of scarce
many weak operations were eliminated, which executives may
resources and produce what people value most. They are connever have shuttered.
cerned with efficiency, not morality. Therefore, consumers
Then there was the spate of corporate scandals of the late
must serve as the moral compass of Corporate America. The
1990s and early 2000s. Companies like Enron, WorldCom,
executives in charge may be obligated to make money for
and Adelphia Communications based their growth on quesshareholders, but they have to satisfy consumers in order to
tionable accounting practices and financial arrangements
meet that goal. In the ideal marketplace, good behavior will be
obscured from public scrutiny. Eventually, their actions were
rewarded and bad behavior will be punished.
RF
52

Region Focus • Spring 2005

Spring 05 Cover FINAL v.5.ps - 4/11/2005 10:52 AM

NEXTISSUE
Corporate Governance

Economic History

It’s been more than three years since accounting scandals at
Enron, WorldCom, and other companies led to the passage of
the Sarbanes-Oxley Act. That legislation was designed to shed
light on corporate misconduct by enhancing disclosure requirements and changing audit rules. How have companies in the
Fifth District responded to these new regulations?

In the late 1950s, leaders from academia,
business, and government envisioned creating a research community in the pine forests
bordering Raleigh, Durham, and Chapel Hill.
That dream became reality, and today
Research Triangle Park is home to more than
100 organizations and 38,000 employees.

Base Closures
In May, the Department of Defense will announce its recommendations for additional closures of military installations.
We’ll look at what’s happened to the community surrounding
Fort Pickett, Va., in rural Nottoway County, since that base was
closed in the mid-1990s.

Job Market for Recent Graduates
This may be the best job market for new graduates since the
late 1990s — though it’s not quite rising to the frenzied levels of
the dot-com boom. Find out what college recruiting offices and
students have to say in this survey of recent grads’ experiences
in getting their careers started.

Interview
A conversation with Robert Whaples, an economic historian at Wake Forest University
and director of EH.Net.

Book Review
Freakonomics: A Rogue Economist
Explores the Hidden Side of Everything

by Steven Levitt and Stephen J. Dubner.

Economics of Indian Reservations
Indian reservations are among the poorest places in the United
States, with per-capita incomes well below the national
average. Why? We’ll travel to one of the Fifth District’s largest
reservations in search of an answer.

Visit us online:
www.richmondfed.org
• To view each issue’s articles
and web-exclusive content
• To add your name to our
mailing list
• To request an e-mail alert
of our online issue posting
The Summer 2005 issue will be
published in July.

Spring 05 Cover FINAL v.5.ps - 4/11/2005 10:52 AM

F R B

R I C H M O N D

Economic Quarterly
T

he Richmond Fed’s Economic
Quarterly contains original
research from the Bank’s economists
and visiting scholars. To be added to
the EQ mailing list or to view the
issues online, please visit
http://www.richmondfed.org

Winter 2005: Vol. 91, No. 1
K Alexander L. Wolman and Fan Ding, Inflation and Changing
Expenditure Shares

K Yongsung Chang and Sun-Bin Kim, On the Aggregate Labor Supply
K John R. Walter, Depression Era Bank Failures: The Great Contagion or the
Great Shakeout?

K John A. Weinberg, Banking Markets in a Decade of Mergers:
A Preliminary Examination of Five North Carolina Markets

Fall 2004: Vol. 90, No. 4
K Thomas M. Humphrey, Ricardo versus Wicksell on Job Losses and
Technological Change

K Andreas Hornstein, (Un)Balanced Growth
K Edward Simpson Prescott, Auditing and Bank Capital Regulation
K Matthew Harris, Raymond Owens, and Pierre-Daniel G. Sarte,
Using Manufacturing Surveys to Assess Economic Conditions

Summer 2004: Vol. 90, No. 3
K J. Alfred Broaddus, Jr., and Marvin Goodfriend, Sustaining
Price Stability

K Marvin Goodfriend, Monetary Policy in the New Neoclassical Synthesis:
A Primer

K Robert L. Hetzel, How Do Central Banks Control Inflation?
K Yash P. Mehra, Predicting the Recent Behavior of Inflation Using Output
Gap-Based Phillips Curves

Spring 2004: Vol. 90, No. 2
K Kartik Athreya, Shame As It Ever Was: Stigma and Personal Bankruptcy
K Margarida Duarte, Monetary Policy and the Adjustment to Country-Specific
Shocks

K Huberto M. Ennis, Some Recent Trends in Commercial Banking
K Roy H. Webb, Which Price Index Should a Central Bank Employ?

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